* Euro pares early losses, Mideast demand prompts short squeeze * More downside risk after Italian debt downgrade, Greek default possibility * Investors wary of buying dollars aggressively before Fed policy announcement By Naomi Tajitsu LONDON, Sept 20 (Reuters) - The euro pared early losses on Tuesday, but stayed near a seven-month low versus the dollar as a ratings downgrade of Italy's sovereign debt fuelled concerns that stronger euro zone countries are caught up in the debt crisis. Speculation Greece is edging closer to a debt default also stung the euro, which fell to $1.3593 in early trade. It recovered to $1.3680 in early European trade due to Mideast demand, which prompted short covering in the single currency. Standard & Poor's cut its sovereign rating for Italy by one notch to A, taking it three notches below Moody's current rating. The move triggered a jump in Italian government bond yields, which was seen keeping the euro under selling pressure. Investors also continued to price in the possibility of a Greek default as Athens waits to see if it can clinch a deal for more bailout funds. Banking sector strains caused by the debt crisis were highlighted by a move by two Chinese state banks to stop trading currency swaps with some European banks. "Any news that brings Greece closer to bankruptcy or a debt restructuring will put the euro under more downside pressure," said Niels Christensen, currency strategist at Nordea in Copenhagen. "I wouldn't be surprised to see a test of $1.35 in the next week," he said. The euro fell as low as $1.3495, its weakest since February, just over a week ago. Despite a darkening debt picture, investors were wary of selling euros aggressively for dollars before a Federal Reserve policy announcement on Wednesday, when it is expected to start shifting its asset holdings into longer maturities to help the sputtering U.S. economy. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Euro could fall to $1.30 or below by year-end-CitiFX link.reuters.com/myf83s Other stories on euro zone debt crisis Euro zone crisis in graphics: r.reuters.com/hyb65p ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^> The euro traded flat on the day, but despite its pullback, many in the market believe the single currency's corrective bounce has fizzled out after it rose above $1.39 last week. Many see a push back towards $1.3495, and a break below that could open way for a test of $1.3410, the 50 percent retracement of its rise from June last year to May this year. Tom Fitzpatrick, a managing director and global head of CitiFX Technicals told Reuters Insider TV he was sceptical about both the mid-term and long-term outlook for the euro. "We could see the dollar outperform the euro not only for a couple of months, but possibly for a couple of years," said Fitzpatrick, adding that the euro could drop below $1.30 before year-end and move towards parity one to two years from now. The single currency traded at 104.50 yen , after falling to 104.00 yen, a whisker away from a 10-year low of 103.90 yen hit last week. The dollar was flat versus a currency basket at 77.155 , and was unchanged versus the yen at 76.50 yen . The Australian dollar rose 0.3 percent to US$1.0240, as investors picked up the currency after Reserve Bank of Australia minutes pared speculation of an interest rate cut in the near term. The high-yielding currency recovered earlier losses suffered after the Italy downgrade had sparked selling in riskier assets, while its New Zealand counterpart fell 0.2 percent. Analysts see a risk that the dollar could be hurt in the near term if the Fed adopts bolder easing steps than markets are expecting on Wednesday when it ends its two-day meeting. But relatively high U.S. inflation may hinder the U.S. central bank from adopting large-scale easing such as more quantitative easing, which would flood the market with dollars and drive its value down, analysts say. Instead, the Fed may to try to push low long-term interest rates even lower this week by tilting towards longer duration bonds in its portfolio, a move known as Operation Twist. Such a measure may not be enough to boost significant demand for riskier assets, and may keep selling pressure on the euro and higher-yielding currencies which could support the safe-haven currencies including the dollar. (Additional reporting by Asia FX team; editing by Anna Willard)

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