* Euro surrenders gains vs dollar
* Fitch downgrades Spain and Italy credit ratings
* Moody’s downgrades UK banks but sterling/dollar firm
By Steven C. Johnson
NEW YORK, Oct 7 (Reuters) - Downgrades for Italy and Spain knocked the wind out of the euro on Friday, and traders said anxiety about Europe’s economy and fragile banks will likely continue to hobble it in the weeks ahead.
Higher-yielding, growth-sensitive currencies such as the Canadian and Australian dollars should fare better, especially after data showed U.S. hiring rose more than expected last month, easing some concern about the world’s biggest economy.
If the view that the United States can avoid recession takes hold, investors may renew borrowing U.S. dollars at near-zero interest rates to fund riskier but more lucrative trades in other currencies and assets, traders said.
That’s a practice that had fallen out of favor in August and September as markets fretted over slower U.S. growth and a worsening euro zone sovereign debt and banking crisis.
The debt crisis continued to hurt the euro, which slipped 0.3 percent to $1.3387 Friday, off a $1.3524 session high.
While it was on track for a slender weekly gain against the dollar — its first in the last three — the euro was still rooted in a downtrend that began at $1.4548 on Aug. 29.
The dollar also rose against the yen and the Swiss franc, up 0.2 percent to 76.80 yen and up 0.6 percent to 0.9266 Swiss francs .
The euro relinquished earlier gains after Fitch cut the credit ratings of Italy and Spain — the third and fourth largest euro zone economies — citing a worsening euro zone debt crisis and fiscal situation in both countries.
“This brings the sovereign debt crisis back into focus and raises the risk for contagion,” said David Song, currency analyst at DailyFX in New York.
“There will be continued reliance on the European Central Bank to do more when the (euro zone) is already struggling to pass a second bailout for Greece. As they try to gain time, things are getting worse.”
Italy and Spain have faced higher borrowing costs as investors worry about their finances, and that has put pressure on European banks who hold their sovereign bonds.
The euro may get a boost if euro zone leaders can cobble together a plan on Sunday to recapitalize banks facing hefty losses.
But Brown Brothers Harriman strategist Mark McCormick said the prospect of a euro zone recession and interest rate cut were gaining traction after the ECB this week announced new funding plans to stabilize banks and the euro zone economy.
“That means the euro probably doesn’t get much momentum even on good news,” he said. “A euro zone recession is still possible and the ECB probably cuts rates before 2012.”
Jens Nordvig, head of G10 currency strategy at Nomura, said the euro will remain under pressure in the fourth quarter and should hit $1.30 before the end of the year.
Sterling may struggle as well, he said. Though it rose 0.7 percent to $1.5545 on Friday , it remained near Thursday’s 14-1/2-month low beneath $1.53, hit after the Bank of England said it would pump another 75 billion pounds into the economy.
While U.S. interest rates are set to remain at zero into 2013, McCormick said the data showing 103,000 new jobs added in September at least suggests the U.S. economy “is not in as bad shape as some people think.”
Any signs of future improvement should benefit the Australian and Canadian dollars, among the hardest hit in recent months as investors cut exposure to risk, he said.
The Australian dollar rose 0.4 percent to $0.9783 and was up about 1 percent on the week, its best since the week ending Sept. 4. The U.S. dollar was up 0.1 percent at 1.0398 Canadian dollars but was down 0.9 percent on the week.