* Euro recovers on short covering after hitting two-month low * But traders cite clear bias to sell the euro * Agencies warn of possible euro zone ratings downgrades * No Fed policy action expected at meeting By Jessica Mortimer LONDON, Dec 13 (Reuters) - The euro recovered from a two-month low versus the dollar on Tuesday but was seen as vulnerable to further selling as the threat of euro zone sovereign downgrades undermined sentiment towards the currency. Short covering helped the euro rebound modestly after it failed to break below a reported barrier at $1.3150, but traders said there remained a clear bias among investors to sell the single currency on any bounce. The euro was up 0.3 percent at $1.3226, having hit a low of $1.3160, leaving the October low of $1.3145 within range. Investors took some encouragement from lower yields at an auction of Spanish short-term debt, while a survey showed German investor sentiment rose unexpectedly in December although worries about the severity of the region's debt crisis remained. Comments from France's candidate for a seat on the European Central Bank's Executive Board, Benoit Coeure, who said the ECB may need to step up its bond-buying to help reduce borrowing costs for some countries, were also seen as positive. "The Spanish auction was reassuring but there is still an Italian auction to come this week and the market will be inclined to push the euro lower from here," said Audrey Childe-Freeman, EMEA head of currency strategy at JP Morgan Private Bank. "The only thing that would be enough to restore confidence for now would be aggressive bond buying by the ECB," she said, but added that repatriation flows could support the euro heading into year-end. Moody's said on Monday it intends to review the credit ratings of all 27 European Union states in the first quarter of 2012, while another ratings agency, Fitch, said pressure on their ratings had risen after last week's EU summit yielded no "comprehensive" crisis solution. Standard & Poor's, the other major rating agency, already has 15 euro zone states on watch for a possible downgrade. "The last blow for the euro was the announcement from the ratings agencies last night," said Niels Christensen, currency strategist at Nordea in Copenhagen. "The technical configuration is turning against the euro. If it breaks below the early October lows then very quickly $1.30 would be in the frame, plus we have thin markets. It all adds up to a clear bias to the downside for euro/dollar." Net euro short positions totalled 95,814 contracts in the week through December 6, according to Commodity Futures Trading Commission data, and market participants said shorts are likely to have increased in the wake of the summit. Although the data suggested a strongly negative sentiment towards the euro, the single currency could gain short-term support as investors take profits on or cover those positions. FALLING RISK APPETITE Pressure on the euro and heightened risk aversion increased the dollar's safe-haven appeal, lifting the dollar index to 79.651, its highest this month, before it dropped back to 79.333. Later on Tuesday, the Federal Reserve will hold its final policy meeting of the year but it is not expected to take any action other than some finishing touches on its communication strategy. Many analysts expect the Fed to wait until a two-day meeting on Jan. 24-25 before launching any new initiatives. U.S. retail sales data will also be released ahead of the Fed meeting. The risk-sensitive Australian dollar was up 0.6 percent at $1.0130, having earlier shed more than 1 cent to a two-week low of $1.0030. Market liquidity was thin ahead of year-end holidays, which may hurt demand in sales of Italian and Spanish bonds on Wednesday and Thursday. Weak results would add to pressure on the euro.

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