* Euro in downtrend but drop likely to be gradual -trader
* Mounting risk aversion supports dollar
* Aussie dips back below parity vs USD
* Worries grow as European bank funding condition tightens (Updates levels, adds comments)
SINGAPORE, Nov 18 (Reuters) - The euro edged higher on Friday as traders covered short positions after its recent drop to a five-week low, but the single currency was expected to remain in a downtrend amid fears the euro zone debt crisis is spiralling out of control.
Selling pressure on the euro has intensified this week on signs that contagion was spreading to core euro zone countries such as France, and the currency is on track for its biggest one-week drop since early September.
The spotlight fell on Spain on Thursday, which had to pay the highest rate to sell its 10-year debt since 1997, just shy of the 7 percent mark seen as unsustainable.
The euro, however, showed some resilience in the wake of the Spanish bond auction, getting a boost from short-covering and holding above a five-week trough of $1.3421 hit on Thursday on trading platform EBS.
"The market is very eager to sell the euro and also eager to take some profits," said Jesper Bargmann, Asia head of G11 spot FX for RBS (LSE: RBS.L - news) in Singapore. "So we are seeing interest on the dips to buy."
Such short-covering interest is likely to persist and limit the speed of the euro's declines, Bargmann said.
"There's plenty of two-way interest in the euro now," he added. "There's a lot of short positions out there and people are eager to book some profit. So it's not an easy trade."
The euro rose 0.2 percent to $1.3479, but is still down roughly 2.4 percent for the week, on track for its biggest weekly percentage decline since early September.
The euro is likely to test its early October low of $1.3145 eventually, but its descent will probably be gradual, said Bargmann at RBS.
"I think we'll break $1.30 but I think it's going to be in a fairly orderly fashion," he said, adding that there were likely to be some spikes and bouts of short-covering in between.
Support for the euro lies at around $1.3405, the 76.4 percent retracement of the October rally. The bottom of the weekly Ichimoku cloud also offers support near that level, coming in at $1.3408.
"The (euro's) direction is probably toward the downside but looking at how the market has been moving and positioning, you have to be wary of short-covering," said a trader for a Japanese brokerage house in Tokyo.
DOLLAR FUNDINS STRAINS
The deepening of the euro zone's debt crisis has caused heightened stress in dollar funding markets this week.
The premium for swapping euros into dollars rose on Thursday, with the three-month cross-currency basis swap around 6 basis points wider at -136 basis points, the most since the 2008 financial crisis.
"The slow motion train crash continues, with USD funding now clearly a bigger issue as contagion spreads more deeply into Spain," said Sebastien Galy, strategist at Societe Generale (Paris: FR0000130809 - news) .
The Australian dollar, which tends to come under pressure in times of market stress, dipped to a five-week low of $0.9966 and was last down 0.3 percent at $0.9977.
"While risks to the downside appear more apparent, it's worth noting that the currency is now oversold on several momentum-based indicators," said David Scutt, a trader at Arab Bank Australia in Sydney.
"Keeping this in mind, should any good news surrounding Europe (Chicago Options: ^REURUSD - news) hit the screens, it's likely to see the Aussie spring higher on the back of short covering."
The dollar dipped 0.2 percent against the yen to 76.86 yen. Wariness about the possibility that Japan (EUREX: FMJP.EX - news) may intervene further in the wake of its massive yen-selling intervention on Oct (KOSDAQ: 039200.KQ - news) . 31, has lent support to the dollar recently.
Increased signs of dollar-funding strains are another factor supporting the dollar, said a trader for a Japanese bank, adding that dollar offers from Japanese exporters are likely to put downward pressure on the dollar towards the month-end. (Additional reporting by Ian Chua in Sydney, Hideyuki Sano in Tokyo)
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