FOREX-Italy and Cyprus fears take toll on euro, yen firms while easing awaited
* Euro wallows near four-month lows vs USD
* Italy's funding costs rise, Cyprus banks set to reopen
* Dollar index hovers at eight-month highs
* Yen slide loses downward momentum as BOJ meeting awaited
By Sophie Knight and Hideyuki Sano
TOKYO, March 28 (Reuters) - The euro languished at four-month lows on Thursday, after a rise in Italy's funding costs delivered an extra blow for the currency already suffering from ramifications of the rescue deal for Cyprus.
The yen gained slightly followed a period of weakening due to expectations - now heavily priced in - of aggressive monetary easing by the Bank of Japan at new governor Haruhiko Kuroda's first policy review on April 3-4.
The common currency limped up 0.1 percent to $1.2790, but remained near a four-month low of $1.2750 hit on Wednesday after a debt auction in Italy saw borrowing costs climb to five-month highs as investors demanded a higher 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 has 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 prepared to reopen its banks for the first time in nearly two weeks, with fears of bank runs prompting the government to impose a raft of tough controls including limiting withdrawals and banning cheques.
"Headline risks for the euro should persist, although a positive turn of events in either country (Cyprus or Italy) 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 euro has important technical support just below $1.27, including a 61.8 percent retracement of its July-Feb rally around $1.2680 and the November trough of $1.2661.
The setback in the euro kept the dollar index up close to its highest level in nearly eight months. The index, which tracks the greenback's performance against a basket of currencies, was last at 83.123, having touched 83.302 on Wednesday.
But the dollar lost ground against the yen, with some analysts saying expectations of easing from the Bank of Japan, which triggered the currency's 15 percent slide against the dollar since mid-November, were losing their potency.
"The market was pricing in 'surprise' easing but there's no surprise anymore, nothing new in Kuroda's statements, so people are inevitably covering their yen shorts," said Masashi Murata, senior currency strategist at Brown Brothers Harriman in Tokyo.
Among other reasons cited by analysts for strength in the yen was Japanese exporters' selling on the next-to-last trading day of their financial year, as well as a fall in Nikkei futures triggered by a slide in Chinese equity markets.
To Murata, 94 yen to the dollar "looks like a strong base, particularly because the U.S. recovery still looks strong."
The dollar grazed 93.98 yen on Thursday before hopping back up to 94.190. It has firm support at 93.78 yen, the 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 that country's banking regulator ordered banks to strengthen checks on underlying assets of a range of wealth management products.
With no major economic news out of Asia on Thursday, the focus was squarely on developments in Europe before markets there and in the U.S. close for the Easter holiday on Friday.
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