* Italy's five-year debt costs highest since October 2012
* Cyprus to ban cashing checks and limit cash withdrawals
* Cyprus capital controls expected to hit foreign transactions
* BoJ likely to start open-ended asset purchases immediately
By Julie Haviv
NEW YORK, March 27 (Reuters) - The euro fell to its lowest level against the U.S. dollar in four months on Wednesday, weighed by a weak Italian bond auction and concerns that Cyprus' recent rescue deal could serve as the pattern for future bailouts in the region.
Italy paid more to borrow over five years than it has since October as lack of progress in forming a new government and worries about Cyprus' bailout hurt demand at a debt auction.
Italian center-left leader Pier Luigi Bersani will report to President Giorgio Napolitano by Thursday on the outcome of talks with other parties about forming a government.
Cyprus, meanwhile, will impose a ban on cashing checks and limit the amount of cash that can be taken out of the country as part of a series of measures to avert a run on the country's banks when they reopen on Thursday, the central bank said.
Cyprus and the European Union, European Central Bank and the International Monetary Fund agreed Monday to restructure the country's two largest banks, forcing shareholders and large depositors at the Bank of Cyprus and Popular Bank of Cyprus to take losses in return for a 10-billion-euro bailout.
"The past few days have been mired by endless speculation over the precedent the bailout of Cyprus might set for other peripheral countries," said Christopher Vecchio, currency analyst at DailyFX in New York.
The euro last traded at $1.2776, down 0.65 percent on the day and off over 3 percent this year. The euro fell as low as $1.2750, its lowest since Nov. 21.
A bleak outlook for the euro zone's economy and the risk of capital flight should continue to weigh on the euro.
Investors bought the safe-haven dollar, pushing the dollar index against major currencies to a 7-1/2 month high.
"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 in London. "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."
EU and ECB officials have sought to quash the suggestion that the Cyprus bank restructuring was a template for future bank bailouts in the euro zone.
The spread between the yields on two-year U.S. Treasuries and their German counterparts has widened to its highest since late December in favor of the former. That is likely to support the dollar, traders said.
"Cyprus is certainly still weighing on the euro, but the bulk of the move lower today was triggered by the Italian debt auction," said Greg Anderson, G10 strategist at CitiFX, a division of Citigroup (NYSE: C - news) in New York.
"Rising Italian borrowing costs and its political situation are both negatives," he said. "Investors are not overly short the euro, so there is plenty of scope for the euro to test the lows of the past cycle."
UPCOMING BOJ MEETING EYED
The yen fared well against the euro as investors preferred the safest, most liquid currencies, given the troubles in the euro zone. The euro last traded down 0.66 percent at 120.63 yen.
Against the dollar, the yen should continue to weaken on the prospect of aggressive monetary easing measures by the Bank of Japan next week. 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 then the yen could recover some lost ground.
The dollar last traded at 94.43 yen, up just 0.02 percent for the day, according to Reuters data.