* Euro slides to $1.2666 in thin Asian trade * Weekend euro zone news hits sentiment; mkt heavily short * Merkel, Sarkozy meet; focus on Spain, Italy debt sales By Neal Armstrong LONDON, Jan 9 (Reuters) - The euro crawled back from a fresh 16-month low to the dollar on Monday as traders trimmed short positions, but further declines were anticipated as worries over sovereign funding kept investors bearish on the currency. Markets were awaiting a meeting between German Chancellor Angela Merkel and French President Nicolas Sarkozy where they will discuss ways to boost growth and final details of a deal to increase fiscal coordination in the euro zone. Sentiment took a further hit over the weekend when German magazine Der Spiegel reported the International Monetary Fund was losing confidence in Greece's ability to clean up its public finances. Also, an adviser to German Finance Minister Wolfgang Schaeuble told a Greek newspaper a 50 percent writedown on Greek debt holdings - a key part of the country's debt swap deal - would not be enough to put it huge debt on a viable footing. "Newsflow from the euro zone is not helping, particularly regarding Greece, and markets are also on the defensive ahead of key event risks this week so there's not too much reason to be overweight the euro," said Geoffrey Yu, currency strategist at UBS. "These are testing times for the currency and the scale of the recent decline seems to have caught some people by surprise." Focus this week will fall on Spain and Italy in the run-up to their first bond auctions of the year, with little sign that investors have started 2012 with improved appetite for the euro zone's riskier assets. The euro hit its lowest level since September 2010 of $1.2666 on trading platform EBS in thin Asian trade, with Tokyo markets shut for a public holiday. Against the yen, the euro hit an 11-year low of 97.28 yen. The single currency later recovered to $1.2766 as traders covered some short positions, trading up around 0.3 percent for the day. Traders reported offers in the $1.2780 zone. Key support for the euro lies near $1.2600, roughly the 76.4 percent retracement of its June 2010 to May 2011 rally and also the late August 2010 low around $1.2690. U.S. jobs data last Friday highlighted the diverging growth outlook between the United States and Europe, suggesting further weakness in the euro/dollar pair. "We're seeing a correlation break in that the euro has started to sell off relative to the dollar when there is decent data," said Yu. Some market players said stop-loss offers exacerbated the euro's drop on Monday but the fall was meeting with bouts of short covering. "Could the euro rebound this week? It had an enormous move on Friday, so we wouldn't be surprised especially since the market is so short euro already," said Kathleen Brooks, research director at FOREX.com. Currency speculators boosted short positions in the currency to record levels in the week ended Jan. 3, data from the Commodity Futures Trading Commission showed on Friday. EURO CROSSES After finishing 2011 some 13 percent below its year high near $1.4940, the euro has started 2012 on a weak note, having shed roughly 1.9 percent so far in January. The drop so far this year has been driven by selling in euro crosses such as euro/Aussie and euro/yen, said Rob Ryan, FX strategist for BNP Paribas in Singapore. "Positioning is beginning to get a little stretched at this stage," Ryan said. "I think we're risking some pretty fast reversals of these moves." Still, the single currency is unlikely to see a sustained rebound unless the euro zone's economic outlook improves, Ryan said, adding that the euro could fall to $1.25 in coming months. The dollar held steady against the yen at 76.89 yen, staying above a two-month low of 76.30 yen hit last week. The dollar held firm against a basket of currencies to trade at a 16-month high of 81.47 in Asia before easing back to 81.063.

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