* Euro near 11-yr low vs yen * Dollar index hits highest in a year * U.S. payrolls in focus, strong number may hit euro * Market sees possible drop to $1.25, then $1.20 By Jessica Mortimer LONDON, Jan 6 (Reuters) - The euro hit 16-month lows against the dollar and sterling on Friday and traded close to an 11-year trough versus the yen, with growing unease about funding pressures in the euro zone pointing to further declines. U.S. payrolls data at 1330 GMT could provide a further dose of optimism on the outlook for the U.S. economy after a measure of private-sector hiring surged in December. Payrolls are tipped to rise 150,000 in December, but many think the figure may be higher. Strong data could help risk sentiment, in theory helping the euro, but many analysts expect it would weigh further on the common currency instead as investors focus on the divergence between the two economies, with the euro zone seen heading towards recession. The market is seen staying on edge and the euro under pressure ahead of Italian and Spanish government bond sales next week, viewed as the year's first big fundraising tests for stuggling euro zone countries. The euro was steady versus the dollar at $1.2781, recovering from an earlier low of $1.2763 hit on trading platform EBS, its weakest since September 2010. It remained vulnerable to further bouts of selling, even though it may be helped periodically by short-covering, as market participants take profit on short euro positions which have reached record high levels. "There is a general tendency to sell the euro on any rallies," said Ankita Dudani, currency strategist at RBS. "Even if we get a strong non-farm payrolls print it would be supportive for risk sentiment but not so for euro/dollar". The euro's drop helped buoy the dollar to 81.062 against a basket of currencies, its strongest in a year. The dollar index was last steady at 80.929. The single currency also hit a 16-month low versus sterling of 82.39 pence, while against the yen it was at 98.62 yen, close to Thursday's 11-year low of 98.451 yen. "The longer the euro zone crisis drags on the more a solution has to come through the monetary route, i.e. through the exchange rate," said Steve Barrow, head of G10 currency research at Standard Bank. "The question is whether the euro continues to fall at a slow pace or whether it starts to fall more aggressively," which could see it fall to $1.20 by the end of the month. Standard Bank currently forecasts euro/dollar at $1.20 in six months' time. CRISIS TALKS As well as next week's debt auctions, the market will await a meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel on Monday for fresh hints on steps they may take to try to resolve the crisis. Investors are sceptical that they will announce anything to allay fears about the troubles facing the euro zone. The talks will centre on new rules to enforce budget discipline across the European Union, but any new treaty would take time to finalise, just as credit rating agencies assess whether to downgrade a clutch of euro zone countries. Traders reported euro selling by real money investors and hedge funds. Renewed falls in the single currency would see it target option barriers at $1.2750, $1.2700 and $1.2650, as well as a large barrier at 98.00 yen, they say. On technical charts, one support area for the euro is seen around $1.2600, the 76.4 percent retracement of the June 2010 to May 2011 rally. A break below $1.2500 is expected to pave the way to a drop towards $1.2000. Investors are particularly concerned about the borrowing costs of Italy, which must pay out 100 billion euros in bond coupons and redemptions in the first four months of 2012 alone. Sarkozy is due to meet Italian Prime Minister Mario Monti later on Friday, ahead of his meeting with Merkel next week. The dollar dipped 0.1 percent against the yen to 77.12 yen , off a two-month low of 76.30 yen hit earlier this week.

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