* Moody's cuts Italy credit rating by two notches
* Pound hovers close to 3-1/2 high against euro
* Steady vs dollar near 5-week low, seen driven by euro
By Michael Szabo
LONDON, July 13 Sterling held near a 3-1/2 year high against a weaker euro on Friday after Moody's cut Italy's credit rating, sending the country's borrowing costs higher and putting further pressure on its struggling economy.
The euro edged down 0.1 percent against the pound to 79.02 pence, in sight of a 78.71 pence trough hit on Wednesday, its weakest since late 2008.
Analysts said trade in sterling would continue to be guided by sentiment towards the euro, which remained vulnerable to further declines against a range of currencies.
"The trend is still being determined by the euro and cable (sterling/dollar) is being dragged with it," said Adrian Schmidt, FX strategist at Lloyds TSB.
He said that should the euro lose further ground against the dollar on the back of the Italian downgrade, sterling could rise to test the 44-month high against the common European currency.
"However, it's Friday and euro/dollar's been falling all week ...so I'm not sure the market has that much appetite to sell off more aggressively today," he added.
Against the dollar the pound was steady at $1.5433 after hitting a five-week low of $1.5393 on Thursday. Further losses were possible against the safe-haven U.S. currency if euro zone debt worries increased and markets turned more risk-averse, analysts said.
Moody's unexpectedly cut Italy's sovereign rating by two notches to Baa2, just two notches above junk status. It warned it could cut it further if Italy's access to debt markets dried up, potentially meaning more pain for the euro.
The downgrade pushed Italian 10-year bond yields back above 6 percent and came at a particularly bad time as the country will later on Friday try to sell 5.25 billion euros in bonds.
Meanwhile, China's economy grew 7.6 percent in the second quarter of 2012 from a year earlier, representing the slowest pace in three years. But the data met forecasts and lifted equity markets as it eased worries of a sharp slowdown in the world's second largest economy. (By Michael Szabo; Editing by John Stonestreet)