LONDON, May 10 (Reuters) - The euro stayed close to a 3 1/2-month low against the dollar on Thursday and was expected to suffer further losses as political deadlock in Greece increased the risk of insolvency and a possible euro exit.
The common currency gained a short-term reprive as stress in Spanish debt markets abated slightly and after Greece secured funds needed for bond repayments.
However, it was expected to continue the firm downward path established since Greece's inconclusive elections at the weekend. With another set of elections likely, doubts are growing that Greece will adhere to austerity measures needed to secure further emergency funding.
The euro was up 0.2 percent at $1.2956, but it stayed not far from $1.29115 hit on Wednesday, its lowest since late January. Analysts were sceptical over its ability to recover after it broke below the $1.2950 level the previous day.
It also traded just shy of an earlier 3-1/2 year low against sterling, which has benefited from investors seeking safer alternatives to the common currency, as the Bank of England left interest rates and its quantitative easing target unchanged.
"We're entering a new chapter of concern for the euro zone and it's not one that can be resolved in the near future," said Tom Levinson, currency strategist at ING, who expected sellers to stamp out any short-covering rallies in the common currency.
Greece averted an imminent funding crisis after the board of the European Financial Stability Facility agreed to release 4.2 billion euros of a scheduled payment.
Ten-year Spanish government bond yields also fell after Spain's government effectively took over Bankia, one of the country's biggest banks, in a bid to restore confidence in a sector laden with bad debts.
However, some in the market worried that Spain's efforts could hurt its already deteriorating finances, with the European Commission expected to forecast the country will miss its deficit reduction targets this year and next.
"It doesn't feel like there's much appetite to take the euro higher, just that we've just curtailed some of the trauma on the downside," said Daragh Maher, currency strategist at HSBC.
Further falls would take the euro towards chart support around $1.2819, the 76.4 percent Fibonacci retracement of its 2012 rally, and then the 2012 low around $1.2624.
Greek Leftist leader Alexis Tsipras gave up his attempt to form a new government on Wednesday, leaving Greek Socialist leader Evangelos Venizelos to make a last-ditch attempt to form a government on Thursday. But the chances looked slim just as Athens risks running out of cash in June.
RATE DECISIONS
The euro fell 0.1 percent against sterling to 80.08 pence , with the pound helped after the BoE paused its 325 billion pound quantitative easing programme.
It traded just shy of an earlier low of 80.01 pence, its weakest since the aftermath of the Lehman Brothers collapse in 2008. It stopped just ahead of a reported options barrier at the psychological 80.00 pence level.
But traders said the market was positioned heavily short of the euro, which may help to slow the pace of its decline.
Meanwhile, the low-yielding yen was expected to stay supported as the latest troubles in the euro zone added to concerns about tepid growth in the United States and China.
The U.S. dollar stood at 79.73 yen, having hit its lowest in nearly three months, at 79.428 per dollar, on Wednesday.
The yen, which tends to outperform at times of economic stress, has recovered most of the losses that followed the Bank of Japan's easing in February.
The Australian dollar was up 0.8 percent at $1.0121 , recovering from a five-month low of $1.0021 hit on Wednesday after upbeat Australian job data reduced expectations of more rate cuts.
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