The euro held firm Tuesday after a choppy session overnight saw a wave of short-covering lift it by more than two cents on hopes that China will bolster Italy by buying its bonds, but traders found few reasons to stay upbeat about the currency.

Mounting fears of a Greek default, a surge in Italian bond yields and steep falls in French bank shares due to their sovereign exposure and threatened cuts to their ratings kept sentiment overwhelmingly bearish.

The euro climbed to around $1.3686 against the dollar after falling to a seven-month low of $1.3495 in the previous session, though weak demand at an Italian bond auction later in the day may see it drop back again.

All eyes are squarely on that seven-month low around $1.35 hit overnight, said Koji Fukaya, director of global foreign exchange research at Credit Suisse Securities in Tokyo.

The downtrend in the euro will surely continue, but my sense is that unless the Italian bond auction goes extremely badly, this level may hold today, he said.

Italy is offering up to 7 billion euros of long-term paper, with the auction in focus after the previous long-term sale drew tepid demand and as the spread of Italian bond yields over German Bunds rose close to a peak around 400 bps hit in August.

On top of that, any weakness in inflation data from France and Spain also out later in the day could fire up expectations that the European Central Bank may cut interest rates.

Markets are also trying to price in a possible ratings downgrade on France's top banks, as well as an Italian sovereign rating cut. Moody's warned on June 17 that it may cut Italy's credit rating in the next 90 days.

Chart-wise, the euro looks heavy after a short-covering rally stalled ahead of the top on the weekly Ichimoku cloud at $1.3705 and the 100-week moving average at $1.3739.

Having failed to bounce back above $1.37, the euro has become extremely vulnerable on the charts. I wouldn't get my hopes up for the auction -- the euro is still a sell, said a trader for a Japanese bank who spoke on condition of anonymity.

But the trader also said that the euro is oversold in the short term and may find some immediate support having fallen about nine cents, or 6 percent, in two weeks from a high of around $1.4548 on August 29.

It is now trading on the verge of the lower Bollinger Band, at $1.3646, and its 14-day relative strength index is hovering around the 30 mark, which is considered to be oversold territory, for the first time in more than nine months.

KNOCK OUT

The Financial Times reported that Italy had asked China to make significant purchases of Italian debt. Italy has seen its borrowing costs spike in recent weeks on doubts about the political will in Rome to tackle its swollen debt.

Against the yen, the euro fell 0.1 percent to 105.40 yen, but was off a 10-year trough plumbed on Monday at 103.90 yen.

Some traders said that the fall through 105.00 and 104.00 in euro/yen overnight has knocked out some Japanese exporter hedges, and that heading into the fiscal half-year end at the end of September they may have to re-sell the common currency.

Risk reversals also showed increasing demand for bets on a lower euro, with the 25 delta one-month euro/yen risk reversal rising to levels not seen in over a year, trading around 4.4 in favor of euro puts.

Market players are cautiously awaiting U.S. Treasury Secretary Timothy Geithner's return trip Friday to Europe, where he will attend a meeting of EU finance ministers to discuss efforts to boost global recovery and cooperate on financial regulation.

The dollar came off seven-month highs against major currencies, falling 0.7 percent to 77.07 after Japanese exporters were detected selling it, helping lift dollar-denominated commodities such as gold, copper and crude oil.

Dollar/yen slipped from a one-month high set on Friday and fell 0.3 percent to 77.02 yen. It has held in a slim range roughly between 76.40 and 77.60 with markets wary of more yen-weakening intervention by Japanese authorities.

The Australian dollar staged a lukewarm rebound, bolstered by the softer dollar and rebounding Japanese equities, but failed to pop back above the 200-day moving average at $1.0385. It last traded at $1.0369.

(Reporting by Antoni Slodkowski and Hideyuki Sano in Tokyo and Ian Chua in Sydney; Editing by Joseph Radford)