* Euro up 0.2 pct vs dollar; S&P ratings threat weighs * Single currency down around 2.6 pct on week so far * Potential for short-covering rally seen limited By Nia Williams LONDON, Dec 16 (Reuters) - The euro edged higher against the dollar on Friday but stayed on track for its worst weekly performance in more than three months, with the threat of euro zone sovereign downgrades keeping investors wary of buying the common currency. The single currency has fallen around 2.6 percent on the week, its worst performance since September, after a key European Union summit last week failed to provide respite to turbulent euro zone bond markets and cash-starved banks. Analysts said a threat of downgrades from rating agency Standard & Poor's, which put a raft of euro zone countries on review ahead of the summit, continued to hang over governments including Germany and France. Rumours of such an event have been circulating since last week, although Italian and Spanish bond spreads over Bunds were tighter on Friday.. The euro rose 0.2 percent to $1.3039, with traders reporting thin end-of-year liquidity. It hovered close to a session high of $1.3045, reached after a well-bid Spanish auction on Thursday and solid U.S. economic data prompted some light short-covering. Some traders said the euro could be poised for a recovery given the extent of its fall this week and topside stop loss orders were seen around $1.3065-$1.31. But most market players said they expected any short-covering rally to be limited by the wider political uncertainty. "Any minute a rating agency might announce they are cutting ratings for a euro zone country. I doubt the summit results will change their mind, there was not really anything sustainable in it," said Lutz Karpowitz, currency analyst at Commerzbank. "From a news-driven point of view it's more likely we will break $1.30 to the downside." Earlier this week the euro dropped to an 11-month low around $1.2945 and a break below that level would open the door to a test of the January low around $1.2871. Analysts said some investors are concerned some European Union states may develop cold feet over proposals on a tighter fiscal regime that were the centerpiece of the summit. Uncertainty over the outcome of Greek debt swap negotiations and signs that some national central banks including Germany's Bundesbank are reluctant to boost lending to the IMF added to the view the crisis may intensify in the New Year. "The first quarter is looking extremely worrying, Greece is looking worse than anticipated and Ireland will potentially need a referendum (on EU treaty changes)," said Derek Halpenny, head of global currency research at Bank of Tokyo-Mitsubishi. "The euro zone could be unravelling and as long as that option remains in the market, the risk of pronounced moves and significant uncertainty remains extremely high." IMPLIED VOLS SLUMP Markets will also be keeping an eye on a confidence vote in the Italian parliament later in the day to speed up approval of a 33 billion euro ($43 billion) austerity package, which the government is expected to win. In the options market, one-month euro/dollar implied volatilities hit a 3-1/2-month low around 12.7, coming further off the elevated levels that prevailed in recent months. Option traders attributed the decline in volatility to many institutions closing their books ahead of the Christmas holidays, rather than to reduced anxiety about the euro zone debt crisis. The euro was steady versus the Swiss franc at 1.2230 francs after sustaining heavy losses on Thursday when the Swiss National Bank held its cap on the franc at 1.20 per euro. The SNB's move knocked back speculation that the central bank might step up their efforts to deter investors from seeking safety in the currency and pushed the euro to a six-week low. A slightly firmer euro saw the dollar index fall 0.2 percent to 80.146, although it remained in sight of an 11-month high of 80.730 hit on Wednesday. Commodity currencies were boosted by dip-buying and stronger bourses in Asia, with the Australian dollar up 0.9 percent at $1.0002. The New Zealand dollar was also well bid, paring the previous day's losses and adding 1.3 percent to $0.7624.

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