(Reuters) - The euro fell to its lowest in more than seven weeks against the U.S. dollar on Friday and was set to weaken further as a disappointing Italian auction stoked fears the euro zone crisis was deepening.

Italy paid a record 6.5 percent to borrow money over six months on Friday and its longer-term funding costs soared far above levels that are seen as sustainable. The rise in borrowing costs came even as the European Central Bank bought bonds in the secondary market.

Signs the euro zone debt crisis was threatening the region's biggest economies such as France and Germany have raised fears of a breakup of the currency bloc. Policymakers remained in disagreement over how to resolve the crisis, with Germany opposed to joint euro zone bonds and a bigger role for the ECB.

Confidence in the region diminishes while the outlook for a solution to the crisis seems as far away as it has ever been, said Brendan McGrath, senior analyst at Western Union Business Solutions in Victoria, British Columbia.

The euro fell 0.7 percent to $1.3255, having dropped as low as $1.3210, based on Reuters data, its lowest since October 4.

Key support lies around $1.3144, the euro's October low, followed by $1.3045, the 61.8 percent retracement of its 2010-2011 rally.

The euro has lost about 1.8 percent this week, on track for a fourth straight week of losses. It came under heavy pressure after lackluster demand at a German bond auction on Wednesday.

Italy's two-year yield rose to a euro-era high above 8 percent and 10-year yields traded above 7 percent, a level that is seen as unsustainable. Belgian bonds were also under pressure ahead of auctions next week.

Strains in the money market added to investor concerns. The euro/dollar one-year cross currency basis swap, which widens when lenders charge more for swapping euro interest payments on an underlying asset into dollars, was at minus 104 basis points -- close to expensive levels of minus 115 bps in late 2008.

SWISS FRANC TUMBLES

The dollar rose as high as 79.702 versus a currency basket .DXY, the highest since early October, as investors sought the liquidity and perceived safety of the U.S. currency.

Unless we see firm action from European authorities, the market is betting the worst is about to happen and the dollar is therefore well bid on demand for liquidity, said Jane Foley, currency strategist at Rabobank.

Against the yen, the dollar rose 0.8 percent to 77.67 after hitting a two-week high of 77.73, according to Reuters data.

The euro hit a seven-week low of 102.46 yen based on Reuters data, before rebounding to 102.86, flat on the day.

The Swiss franc tumbled against the dollar and euro on speculation the Swiss National Bank may raise the ceiling on euro/Swiss franc from the current 1.20 level.

The dollar rose to 0.9330 Swiss franc, a near 8-month high and last traded up 1 percent at 0.92890. It was on track for a gain of 1.3 percent this week, its fourth straight weekly advance.

The euro rose 0.3 percent to 1.2306 francs, after hitting a session high of 1.2380.