* Short covering boosts euro ahead of weekend
* Debt crisis still points to weaker single currency
* Interbank funding strains boost dollar demand (Updates levels, adds details, comments)
LONDON, Nov 18 (Reuters) - The euro rose against the dollar on Friday as investors unwound bearish bets on the single currency to book profits ahead of the weekend but, with the euro zone debt crisis escalating, appetite to sell on upticks was high.
Pressure was mounting on the European Central Bank to step up its bond-buying programme with Italian and Spanish bond yields close to unsustainable levels and plummeting demand from other, real-money investors.
Until a solution emerges that makes the ECB the lender of last resort, any gains in the euro are likely to be fleeting.
"With so much up in the air there's nothing else to focus on apart from the immediate, which is that the euro zone looks to be heading into the precipice. Ahead of the weekend I don't think anyone is ready to counter that view," Jane Foley, senior currency strategist at Rabobank.
The euro rose 0.4 percent to $1.3510, not far from its five-week low of $1.3421 struck on Thursday and still down roughly 2 percent for the week.
Support for the single currency lies at around $1.3405, the 76.4 percent retracement of last month's rally from around $1.3145 on Oct (KOSDAQ: 039200.KQ - news) . 4 to a high of $1.4248 on Oct. 27. Large option expiries at $1.3500 and $1.3550 are also likely to sway trade.
"The market has an appetite to take on new shorts because without the ECB there doesn't seem to be any other buyer in the European sovereign debt market," Foley said.
Bond market experts polled by Reuters saw a 50/50 chance that the ECB will expand bond purchases to engage in outright quantitative easing.
Prospects for the euro have dimmed this week on signs that the crisis was spreading to core euro zone countries such as France, with most investors still looking to sell into every rally.
With German bond yields no longer falling as peripheral yields rise, analysts suggested that portfolio adjustments were not just moving from peripheral debt to core Bunds, but that investors were abandoning the euro zone altogether.
Traders say that since the bulk of investors have already been running bearish positions on the euro in the past few months there is limited scope for the currency to fall further, despite what some politicians have described as the worst crisis in the region since World War II.
While highlighting the risk that the short squeeze could push euro/dollar higher in the near term, Commerzbank (EUREX: CBKF.EX - news) strategists said the prevailing trend was for a lower euro.
"Courageous market participants can sell the euro around $1.3550-60, we would start shortening euro/dollar at $1.3650," the bank said in a note.
FUNDING STRAINS
With investors shunning euro zone assets, funding strains were increasing for euro zone financial institutions, boding ill for the euro and other riskier assets while offering support for the perceived safety of the U.S. dollar.
The premium for swapping euros into dollars rose, with the three-month cross-currency basis swap hitting 138.5 basis points, the highest since the 2008 financial crisis.
"So far this has not had a dramatic effect on the euro, but it is likely to be behind some of the recent weakening," said FxPro's chief economist Simon Smith.
Analysts said high funding costs were pushing banks into shorter duration funding and could spread into spot currency markets, weighing on the euro.
With most investors preferring safety, the yen outperformed the dollar. The dollar dipped to a two-and-a-half week low against the yen of 76.63 yen.
"Generally safe havens are doing very well at the moment and once you've filled up your exposure on dollars, the yen is the next one in line, irrespective of whether you might be worried about intervention," said Adam Myers, senior FX strategist at Credit Agricole (Milan: ACA.MI - news) in London.
This fall extended the yen's slow creep back towards levels where Japanese authorities intervened on Oct. 31 to weaken the currency. However, Myers said the current pace of strengthening meant another round of intervention was unlikely to come until next year.
The Swiss franc also outperformed the dollar, pushing dollar/Swiss franc down 1 percent on the day to 0.91160 francs. The dollar was last trading at 0.9145 francs, down 0.8 percent on the day. (Additional reporting by Pratima Desai; Editing by Susan Fenton)
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