* ECB's Nowotny sees grounds for giving ESM a banking license
* Moody's cuts outlook on EU stability facility to negative
* Euro break below $1.20 would open test of 2010 low (Updates prices)
By Wanfeng Zhou
NEW YORK, July 25 (Reuters) - The euro rose against the dollar for the first time in six days on Wednesday after a European Central Bank official said he could see grounds for giving the euro zone bailout fund a banking license that would increase its crisis fighting firepower.
The comments from Ewald Nowotny, a member of the ECB's Governing Council, prompted a flurry of short-covering and helped the euro rebound from a two-year low as investors who had bet against the single currency were squeezed out of those positions.
Nevertheless, many analysts said the downtrend for the euro remained intact. While a banking license would enable the bailout fund to borrow unlimited central bank money to fight the debt crisis, it is still just an idea and one that may not come to fruition given other ECB officials' opposition.
"Just the prospect that you can see an alternative solution to help prop up Europe is being viewed as a positive," said Gareth Sylvester, senior currency strategist at Klarity FX in San Francisco.
"The reality is that it's simply an idea and nothing more than that just yet," he said. "The actual EU constitution would have to be amended to give (the European Stability Mechanism) those powers and it has to be ratified by all member states."
The euro hit a session high of $1.2169, recovering from a two-year low of $1.2040 set on Tuesday. It was last up 0.8 percent at $1.2154.
The euro garnered an added boost after Spain and France said on Wednesday in a joint statement that for stability in the euro area, the adoption of a single supervisory mechanism for the bloc's banks is needed by the end of this year..
Against the yen, the euro rose as high as 95.20 yen , having carved out a 12-year low of around 94.11 earlier in the week. It was last up 0.8 percent at 95.01 yen.
The dollar was little changed at 78.15 yen.
MORE PAIN FOR SPAIN
Sentiment toward the euro remained bearish given spiraling Spanish borrowing costs that have fueled concerns the country will need a full sovereign bailout.
A break below support at the psychologically important level of $1.20 would open up a test of the 2010 low of $1.1875.
"It's going to be a slow grind down towards that - two steps backward and one step forward," said Fabian Eliasson, vice president of currency sales at Mizuho Corporate Bank in New York. "Volatility is just too high to see it going straight down."
Yields on Spanish debt have jumped since last week when the region of Valencia said it would need financial help from Madrid, with investors concerned other indebted regions will also seek aid.
As speculation grew that Spain, the fourth-largest economy in the euro zone, may need a full-scale sovereign bailout, investors were worried that Europe's bailout fund would have little money left to support other troubled countries including Greece, Italy and Portugal.
Delivering yet more bad news for Europe, Moody's changed the outlook on its provisional top-notch rating for the European Financial Stability Facility to negative, while Egan-Jones on Wednesday cut Italy's sovereign rating.
Moody's earlier in the week changed its outlooks for Germany, the Netherlands and Luxembourg to negative. All three are guarantors for the European Financial Stability Facility, with Germany holding the largest share at just over 29 percent.
The U.S. dollar briefly pared losses against the euro after data showing new U.S. single-family home sales in June fell by the most in more than a year dented risk appetite. But the impact was short-lived as the data fueled expectations of further stimulus from the Federal Reserve. (Additional reporting by Nick Olivari; Editing by Leslie Adler)