(Reuters) - The euro edged higher against the dollar on Friday but stayed on track for its worst weekly performance in more than three months, with the threat of euro zone sovereign downgrades keeping investors wary of buying the common currency.
The single currency has fallen around 2.6 percent on the week, its worst performance since September, after a key European Union summit last week failed to provide respite to turbulent euro zone bond markets and cash-starved banks.
The euro rose 0.15 percent to $1.3034, with traders reporting thin end-of-year liquidity. It held above the $1.30 level and hovered close to a session high of $1.3045, reached on light short-covering prompted after Thursday's well-bid Spanish auction on Thursday and solid U.S. economic data.
There's a bit of consolidation in the euro after a couple of days of heavy selling, said UBS currency strategist Chris Walker.
People are still pretty short of euros and it's taking a lot to push it lower.
Analysts said a threat of downgrades from rating agency Standard & Poor's, which put a raft of euro zone countries on review ahead of the summit, continued to hang over governments including Germany and France.
Rumors of such an event have been circulating since last week, although Italian and Spanish bond spreads over Bunds were tighter on Friday. .
Some traders said the euro could be poised for a recovery given the extent of its fall this week and topside stop loss orders were seen around $1.3065-$1.31. But most market players said they expected any short-covering rally to be limited by wider political uncertainty.
Any minute a rating agency might announce they are cutting ratings for a euro zone country. I doubt the summit results will change their mind, there was not really anything sustainable in it, said Lutz Karpowitz, currency analyst at Commerzbank.
From a news-driven point of view it's more likely we will break $1.30 to the downside.
Earlier this week the euro dropped to an 11-month low around $1.2945 and a break below that level would open the door to a test of the January low around $1.2871.
Analysts said investors were concerned some European Union states may develop cold feet over proposals on a tighter fiscal regime that were the centerpiece of the summit.
Uncertainty over the outcome of Greek debt swap negotiations and signs some national central banks, including Germany's, are reluctant to boost lending to the IMF added to the view the crisis may intensify in the New Year.
The first quarter is looking extremely worrying, Greece is looking worse than anticipated and Ireland will potentially need a referendum (on EU treaty changes), said Derek Halpenny, head of global currency research at Bank of Tokyo-Mitsubishi.
The euro zone could be unraveling and as long as that option remains in the market, the risk of pronounced moves and significant uncertainty remains extremely high.
There was some relief, however, as Italian Prime Minister Mario Monti's government won a parliamentary confidence vote on its austerity package.
IMPLIED VOLS SLUMP
In the options market, one-month euro/dollar implied volatilities hit a 3-1/2-month low around 12.7, coming further off the elevated levels that prevailed in recent months.
Option traders attributed the decline to many institutions closing their books ahead of the Christmas holidays, rather than to reduced anxiety about the euro zone debt crisis.
The euro was steady versus the Swiss franc at 1.2240 francs after sustaining heavy losses on Thursday when the Swiss National Bank held its cap on the franc at 1.20 per euro, dampening talk that they may raise the peg.
A slightly firmer euro saw the dollar index .DXY fall 0.2 percent to 80.164, although it remained in sight of an 11-month high of 80.730 hit on Wednesday.
Commodity currencies were boosted by dip-buying and stronger bourses in Asia, with the Australian dollar up 0.7 percent at $0.9983. The New Zealand dollar was also well bid, paring the previous day's losses and adding 1.25 percent to $0.7618.