n barrier at $1.29
* News of JPMorgan trading loss dents risky assets
* Aussie sags after China industrial output disappoints
* Dollar index hits two-month high as safety sought
By Anirban Nag
LONDON, May 11 (Reuters) - The euro climbed from a 3-1/2-month low on Friday on hopes that a Greek government may be formed soon, although gains could be temporary with broad risk sentiment suffering on weak Chinese data and JPMorgan's shock trading losses.
Those concerns lifted the safe-haven U.S. dollar and hurt growth-linked currencies like the Australian dollar, with the euro seen particularly vulnerable to more losses as worries about the Spanish banking sector and the government's ability to check its budget deficit mounted.
The European Union's executive Commission forecast Spain would miss its 2012 deficit target by a big margin. Its spring economic forecast released on Friday saw Spain's deficit rising to 6.4 percent of gross domestic product from a previous estimate of 5.9 percent.
That has left investors fretting about whether the euro zone debt crisis will ensnare the euro zone's fourth-largest economy while the risk of Greece exiting the euro zone remains high after inconclusive election results on Sunday threw the country into political disarray.
The euro fell to $1.2905 on trading platform EBS, its lowest level since late January, before recovering to $1.2940, broadly flat on the day. Traders said a reported euro option barrier at $1.2900 was the near term focus on the downside, while offers at $1.2980 were likely to check near term gains.
"It is a combination of some bearish positions being squeezed and speculation that a government in Greece could be formed that is driving the euro higher," said Ankita Dudani, G-10 currency strategist at RBS Global Banking.
"This is a small move and can easily be reversed during the course of the day."
Greek conservative leader Antonis Samaras said on Friday there were still hopes a government could be formed after Sunday's inconclusive election to avoid a repeat poll. .
Earlier, the euro and growth-linked currencies came under renewed pressure as investors shunned risky assets after JPMorgan Chase & Co said on Thursday that it suffered a trading loss of at least $2 billion from a failed hedging strategy.
The news undermined investor confidence with fears that other banks may also be set to uncover trading losses weighing on sentiment.
Both the dollar and the yen, safe haven currencies that tend to strengthen in times of market stress, rose. The euro was flat on the day at 103.35 yen, not far from a three-month low of 102.76 yen hit earlier this week.
AUSTRALIAN DOLLAR EYES PARITY
Adding to the negative tone across financial markets, Chinese industrial production weakened sharply in April as investment slowed to its lowest level in nearly a decade, coming in well below forecasts.
That took a toll on growth-linked currencies like the Australian and New Zealand dollars. The Australian dollar, which is sensitive to news from China, Australia's largest export market, was now looking set to drop below parity against the U.S. dollar.
The Australian dollar was down 0.3 percent at $1.0042 , having fallen to $1.0018, its lowest level in nearly five months. It was on track to end the week down more than 1 percent, taking losses to around 3.7 percent so far this month.
The souring in risk appetite comes at a time when the euro is likely to remain weak due to increased political uncertainty in the euro zone and widespread concerns about the health of Spanish banks.
Market players said any boost from a solution to the Greek political deadlock could prove to be fleeting as concerns about Spain's banking sector would drive investors to take a bearish view on the euro.
"The Spanish banks' problems and now the souring risk dynamics are all negative for the euro," said Jeremy Stretch, head of currency strategy at CIBC World Markets.
"I would not be surprised if it makes an attempt to drop below $1.2900 later in the session as there are plenty of reasons to go short ahead of the weekend. All this means that the U.S. dollar and the yen will be supported."
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