* Euro wallows at four-month lows vs USD
* Italy's funding costs rise, Cyprus banks set to reopen
* Dollar index hovers at eight-month highs
By Ian Chua and Hideyuki Sano
SYDNEY/TOKYO, March 28 (Reuters) - The euro languished at four-month lows on Thursday, having suffered a further setback as a rise in Italy's funding costs weighed on markets already worried about the ramifications of Cyprus' controversial rescue deal.
The yen firmed as Japanese exporters repatriated funds ahead of their financial year-end, though expectations of aggressive monetary easing by the Bank of Japan kept the currency in check.
The common currency was at $1.2785, flat on the day but down about 7 percent since peaking at $1.3711 last month and near four-month low of $1.2750 hit on Wednesday.
It has important technical support just below $1.27, including a 61.8 percent retracement of its July-Feb rally around $1.2680 and targeting the November trough of $1.2661.
Against the yen, the euro dipped to a fresh one-month low around 119.95 before edging back to 120.70.
The euro came under renewed pressure after a debt auction in Italy saw borrowing costs climb to five-month highs as investors demanded more premium in the face of prolonged political uncertainty.
Italian centre-left leader Pier Luigi Bersani was left with only slim hope of forming a government after talks with rival party leaders ended with rejection from Beppe Grillo's 5-Star Movement.
"If Italy will have to hold a re-election, that will surely remind the market of a fall in the euro after Greece was forced to hold a re-election last year," said Ayako Sera, market economist at Sumitomo Mitsui Trust bank.
Markets were also nervous as Cyprus prepares to reopen its banks for the first time in nearly two weeks after having secured aid from international lenders.
Fears of a bank run have prompted the government to impose a raft of tough controls including limiting withdrawals and banning cheques.
The Cyprus rescue plan, which imposes heavy losses on depositors in the country, spurred worries that depositors and bond investors may pull money out of some other euro zone countries perceived to be weak.
"Headline risks for the euro should persist, although a positive turn of events in either country would probably come as a greater surprise given the market's subdued expectations," said Vassili Serebriakov, strategist at BNP Paribas.
"Our technical analyst highlights that a break of the $1.2806 technical support level opens the way for a decline to $1.2737."
The setback in the euro saw the dollar index jump to a near eight-month high. The index, which tracks the greenback's performance against a basket of currencies, was last at 83.145, having touched 83.302 on Wednesday.
Against the yen, the dollar fell 0.3 percent 94.20, due largely to Japanese exporters' selling ahead of their financial year end on March 31.
The yen is still waiting for the Bank of Japan (BOJ) to deliver aggressive easing polices already priced into markets. The dollar has rallied more than 20 percent against the yen since September, hitting a 4-1/2 year high of 96.71 earlier this month.
The dollar has firm support at 93.78 yen, kijun line on its daily Ichimoku charts.
The greenback also outperformed commodity currencies as some investors cashed in on recent solid gains ahead of the Easter holidays.
The Australian dollar fell 0.2 percent to $1.0425, pulling back from a two-month high of $1.0497 set on Tuesday, as Chinese shares tumbled after the country's banking regulator ordered banks to strengthen checks on underlying assets of a range of wealth management products.
There is no major economic news out of Asia on Thursday, leaving the focus squarely on developments in Europe.