* Euro hits fresh 4-month low versus dollar
* Worries grow after Cyprus deal, euro may drop to $1.26
* Dollar index hits 7-1/2 month high, yen recovers
By Anirban Nag
LONDON, March 27 (Reuters) - Mounting concerns that Cyprus's rescue deal could see private investors foot the bill in future euro zone bailouts and renewed uncertainty in Italy pushed the euro down to a four-month low against the dollar on Wednesday.
More losses were expected given a soured outlook for the euro zone economy and a risk of capital flight weighing down on sentiment. The euro fell 0.6 percent on the day to $1.2782, its lowest since late November (Xetra: A0Z24E - news) , and down three percent on the year.
Hedge funds were cited as big sellers.
The euro's drop below support at its 200-day moving average of $1.2881 on Tuesday, left it vulnerable to more losses towards its mid-November low of $1.2661, traders said.
Investors bought the more liquid dollar, often seen as a refuge during times of the uncertainty, pushing the dollar index against major currencies to a 7-1/2 month high of 83.192.
The euro's losses came as demand for Italian bonds at an auction was hurt by investor nerves over a lack of progress in forming a government in Rome.
Italy's anti-establishment 5-Star Movement flatly rejected overtures from centre-left leader Pier Luigi Bersani, who is trying to muster the numbers to form a government after last month's deadlocked general election.
Cyprus, meanwhile, was finalising capital controls to prevent a run on the banks by depositors anxious about their savings after the country agreed to a rescue package with international lenders.
"It is the risk of capital flight out of Cyprus that is worrying," said Mankash Jain, head of FX and Investment Management at hedge fund Solo Capital. "Investors would want to hold the dollar or German Bunds in such a scenario. We see the euro going only one way--and that is down."
Investor (Other OTC: IVSBF - news) worries about their holdings in the euro zone intensified after Eurogroup head Jeroen Dijsselbloem told Reuters on Monday that the Cyprus deal, where private bondholders and depositors have to take hefty losses instead of the taxpayer, could shape future bank rescues.
The European Central Bank sought to quash that suggestion on Tuesday, insisting Cyprus was a unique case, but this was not enough to allay fears.
"After the deal for Cyprus there is concern about what would happen if another country were to ask for financial help," said Niels Christensen, currency strategist at Nordea. "It is difficult to point at positive factors for the euro."
The spread between the yields on two-year U.S. Treasuries and their German counterparts has widened to its highest since late December in favour of the former. That is likely to support the dollar, traders said.
The yen recovered as investors preferred the most liquid currencies given the troubles in the euro zone. The euro was down 0.6 percent against the yen at 120.65 yen while the dollar was slightly lower at 94.30 yen.
The yen had earlier fallen against the dollar on the prospect of aggressive monetary easing measures by the Bank of Japan next week after the Nikkei business daily said the central bank will boost bond buying at its meeting on April 3-4.
Sources also told Reuters the BOJ would likely start open-ended asset purchases immediately rather than in 2014, as originally agreed in January, and also buy longer-dated bonds.
But with aggressive easing by the BOJ widely expected, there is a risk that it could fall short and that could see the yen recover some lost ground.