* Euro recovers early losses, Mideast demand prompts short squeeze * Sentiment low on Italian debt downgrade, Greek concerns * Investors wary of buying dollars aggressively before Fed policy announcement By Naomi Tajitsu LONDON, Sept 20 (Reuters) - The euro pared losses on Tuesday as investors who sold the shared currency after a cut in Italy's credit rating bought it back, although it looked vulnerable to renewed selling on any further signs that the bloc's debt crisis is worsening. Relief that Greece fully paid two bond coupons amounting to 769 million euros helped support the euro, forcing market players to reverse short-term bets the currency would fall. The euro was last up 0.1 percent at $1.3700, paring losses from an earlier fall to $1.3593. Traders cited Middle Eastern demand and said bids from macro funds would provide support around $1.3650-60. A 1.4 percent rise in European shares propped up the euro, as did a cut back in bets in favour of the U.S. currency ahead of a policy announcement by the Federal Reserve on Wednesday. The U.S. central bank is expected to announce more monetary stimulus to kickstart economic recovery, and may leave the door open to additional quantitative easing. "The market came in after the downgrade anticipating more euro weakness. It's been caught wrong footed and that's why we've had an amplified move higher," said Daragh Maher, senior currency strategist at Credit Agricole CIB. "There's a reluctance to be aggressively long on the dollar going into the Fed. Even if they don't announce QE3 they could suggest they may in the future." The euro recovered losses suffered after Standard & Poor's cut its sovereign rating for Italy by one notch, taking it three notches below Moody's current rating. Despite the claw back in the single currency, big gains were unlikely given that investors continue to price in the possibility of a Greek default as Athens waits to see if it can clinch a deal for more bailout funds. "Any news that brings Greece closer to bankruptcy or a debt restructuring will put the euro under more downside pressure. I wouldn't be surprised to see a test of $1.35 in the next week," said Niels Christensen, currency strategist at Nordea in Copenhagen. Last week the euro fell as low as $1.3495, its weakest since February. A break below that could open the way for a test of $1.3410, the 50 percent retracement of its rise from June last year to May this year. FED RISKS The single currency's intraday recovery quelled euro/dollar implied volatility. One-month implied vol traded around 15.9 percent, retreating from 16.25 earlier in the day. One-week vol pulled back to 16.0 from 17.0, but a further slide was unlikely given the risk volatility will stay high ahead of the Fed announcement. One-month risk reversals show a slightly strengthening bias towards bets to sell the euro. The euro traded at 104.76 yen , after falling to 104.00 yen, a whisker away from a 10-year low of 103.90 yen hit last week. The dollar slipped 0.1 percent versus a currency basket , and was flat versus the yen at 76.58 yen . The Australian dollar rose 0.6 percent to US$1.0270, benefiting from a short squeeze in higher-risk currencies, while the New Zealand dollar pared earlier losses to trade flat at US$0.8229. Investors trimmed long positions in the dollar before the Fed's decision. It is expected to start shifting its asset holdings into longer maturities, seeking to stimulate the economy by easing long-term borrowing costs for companies and households. 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, such as another round of asset purchases, known as quantitative easing. Such a move would flood the market with dollars and drive the value of the U.S. currency lower. Instead, the Fed may focus on tilting towards longer duration bonds in its portfolio, a move known as Operation Twist. This, however, may not be enough to boost demand for riskier assets significantly, and could keep selling pressure on the euro and higher-yielding currencies. (Additional reporting by Nia Williams; Editing by Ruth Pitchford)

Source