Updates prices, adds Italian bond auction)

By Michael Szabo

LONDON, July 13 (Reuters) - Sterling held near a 3-1/2 year high against a weaker euro on Friday after Moody's cut Italy's credit rating, sending the country's borrowing costs higher and putting further pressure on its struggling economy.

The euro edged down 0.2 percent against the pound to 78.94 pence, nearing a 78.71 pence trough hit on Wednesday, its weakest since late 2008.

Analysts said trade in sterling would continue to be guided by sentiment towards the euro, which remained vulnerable to further declines against a range of currencies.

"The trend is still being determined by the euro and cable (sterling/dollar) is being dragged with it," said Adrian Schmidt, FX strategist at Lloyds TSB.

He said that should the euro lose further ground against the dollar on the back of the Italian downgrade, sterling could rise to test the 44-month high against the common currency.

"However, it's Friday and euro/dollar's been falling all week ...so I'm not sure the market has that much appetite to sell off more aggressively today," he added.

Against the dollar the pound was up 0.15 percent at $1.5445 after hitting a five-week low of $1.5393 on Thursday. Further losses were possible against the safe-haven U.S. currency if euro zone debt worries increased and markets turned more risk-averse, analysts said.

Moody's unexpectedly cut Italy's sovereign rating by two notches to Baa2, just two notches above junk status, warning further cuts could be on the cards if Italy's access to debt markets dried up. But the country passed a key market test hours after the downgrade, selling the planned amount in bonds at an auction on Friday that pushed the country's three-year borrowing costs well below 5 percent. Ten-year Italian government bond yields briefly pared gains after the auction, continuing to trade around 6 percent. Meanwhile, China's economy grew 7.6 percent year on year in the second quarter, its slowest pace in three years. But the data met forecasts and lifted equity markets as it eased worries of a sharp slowdown in the world's second largest economy.

Analysts also expected worries about a weak UK economy to keep sterling under pressure against the dollar, even as it continues to benefit from investors seeking alternatives to the euro.

Data on Friday showed UK construction output dropped 6.3 percent year-on-year in May, adding to concerns the UK may have contracted for a third consecutive quarter in the three months to the end of June. Editing by John Stonestreet)

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