* Short covering, boosts euro ahead of weekend
* Debt crisis still points to weaker single currency
* Interbank funding strains boost dollar demand (Updates prices, adds details, comments, changes byline, dateline, previous LONDON)
NEW YORK (Frankfurt: A0DKRK - news) , Nov 18 (Reuters) - The euro rose against the dollar on Friday on speculation the European Central Bank may start lending to the International Monetary Fund to bail out troubled euro zone economies and as Italian and Spanish bond yields retreated.
Sentiment toward the euro remained bearish, however, and the common currency was 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 bloc.
The European Central Bank again intervened in the secondary market to help ease tensions on debt issued by some of the troubled countries. Pressure was growing on the ECB to step up its bond-buying activity after Italian and Spanish yields hovered near unsustainable levels.
"Some relief in European bond markets and ongoing speculation about how the ECB might help have provided some temporary relief to markets," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto.
"We see today's rally as temporary and continue to prefer to play the euro from the short side," she added.
The euro rose more than 1 percent to a session peak of $1.3614 on Reuters data, pulling away from a five-week low of $1.3420 struck on Thursday. It last traded at $1.3562, still up 0.8 percent on the day.
Some investors closed their bets against the euro ahead of the weekend, which also boosted the euro, and gains accelerated after automatic buy orders were triggered around $1.3550.
Support 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.
Speculation of the ECB taking a more forceful role in stemming the debt crisis has gained traction in recent days. On Thursday, European officials said there have been discussions about the central bank possibly lending to the global lender, which would give it enough money to bail out bigger euro zone countries. [ID:nL5E7MH2MW]
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]
FUNDING STRAINS
While the euro could push higher in the near term as a short squeeze continues, the prevailing trend remains for a lower euro.
"Courageous market participants can sell the euro around $1.3550-60, we would start shortening euro/dollar at $1.3650," Commerzbank (Other OTC: CRZBF.PK - news) bank strategists wrote to clients.
There are signs that investors have stopped shifting money into the relatively safer German bunds and are instead abandoning the euro zone altogether, with German bond yields no longer falling as peripheral yields rise.
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 138.5 basis points on Friday, the highest since the 2008 financial crisis. [ID:nN1E7AG18W]
"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. [ID:nL5E7MG4HG]
The safe-haven Japanese yen and Swiss franc gained. The dollar slid as low as 76.575 , the weakest since Japan (EUREX: FMJP.EX - news) 's massive intervention on Oct. 31, and was last down 0.3 percent at 76.78. The dollar also lost 0.9 percent to 0.9129 Swiss franc . (Additional reporting by Nia Williams in London; Editing by Chizu Nomiyama)
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