* Short covering, ECB boost euro ahead of weekend
* Debt crisis still points to weaker single currency
* Interbank funding strains boost dollar demand (Updates prices, adds quotes and graphics)
NEW YORK (Frankfurt: A0DKRK - news) , Nov 18 (Reuters) - The euro rose against the dollar on Friday on the possibility the European Central Bank will lend to the International Monetary Fund to bail out bigger euro zone economies and as borrowing costs for Italy and Spain eased.
Sentiment on the euro, however, remained bearish, with the common currency headed for a third straight week of losses as fears persisted that the debt crisis could engulf major euro zone states such as France and trigger a break-up of the 17-nation bloc.
Yields on Italian and Spanish bonds eased after the ECB stepped in to stabilize the market, but fears remain that both countries' borrowing costs are at unsustainable levels. [ID:nL5E7MI24O]
Euro zone officials said there have been discussions that the ECB could lend to the IMF (Berlin: MXG1.BE - news) to provide the fund with enough money to bail out even the biggest euro zone countries. [ID:nL5E7MH2MW] Pressure has also mounted on the ECB to step up its bond purchases.
Either approach would be satisfactory, said Andrew Busch, senior currency strategist at BMO Capital Markets in Chicago, "The broader point is that the ECB is finding a way to stabilize the European debt crisis," he said.
"This third-party lending arrangement not only works around ECB laws, but also provides an avenue for the ECB to create enough funding to stabilize the crisis while maintaining its appearance of independence," he added.
The euro last traded up 0.5 percent at $1.3524 on Reuters data, pulling away from a five-week low of $1.3420 struck on Thursday. On the week, the euro was down 2 percent versus the dollar.
The euro's improvement reflects hope for a solution, rather than strong confidence that such a solution will be achieved, said Nick Bennenbroek, head of currency strategy at Wells Fargo.
"For the next week and in the context of choppy trading, our bias is for U.S. dollar strength and global currency weakness."
Many analysts believe the only way to stem the contagion in Europe (Chicago Options: ^REURUSD - news) is for the ECB to buy up large quantities of bonds, effectively the sort of "quantitative easing" undertaken by the U.S. and British central banks.
Bond market participants polled by Reuters saw a 50/50 chance that the ECB will expand bond purchases to engage in outright quantitative easing. [ID:nL9E7J203E]
Support for the euro lies near $1.3405, the 76.4 percent retracement of last month's rally from around $1.3144 on Oct (KOSDAQ: 039200.KQ - news) . 4 to a high of $1.4247 on Oct. 27.
Spanish elections set for Sunday could help support a rise in the euro against the dollar in the very near-term, because the opposition party, which is seen as favoring austerity measures, is expected to win. But most see a downward trend in the euro.
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Analysis of policy options [ID:nL5E7MF2XJ]
Other stories on euro zone debt crisis [ID:nL5E7LR1WL]
Countdown for euro zone rescue [ID:nL5E7MF2XJ]
Analysis on difficulty of breakup [ID:nL5E7MF1PJ]
Euro zone crisis in graphics http://r.reuters.com/hyb65p
Interactive timeline http://link.reuters.com/rev89r
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With investors shunning euro zone assets, funding strains were increasing for euro zone financial institutions. The premium for swapping euros into dollars rose, with the three-month cross-currency basis swap hitting its highest level since the 2008 financial crisis. [ID:nN1E7AG18W]
Analysts said high funding costs were pushing banks into shorter duration funding and could spread into spot currency markets, weighing on the euro. [ID:nL5E7MG4HG]
Against the yen, the dollar slid as low as 76.575 on trading platform EBS , the weakest level since Japan (EUREX: FMJP.EX - news) 's massive intervention on Oct. 31. It was last down 0.1 percent at 76.92. (Additional reporting by Wanfeng Zhou in New York and Nia Williams in London; Editing by Leslie Adler)
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