* Euro drops to fresh 3-1/2 year low vs sterling
* Trade-weighted sterling at 2-month high
* Investors look ahead to Fed Chairman's testimony
By Anirban Nag
LONDON, July 16 (Reuters) - Sterling rose to a 3-1/2 year high against a struggling euro on Monday as investors, worried about growing risks to Italy and Spain's finances, stepped up sales of the common currency and sought the relative safety of UK assets.
It also rallied against the dollar after U.S. retail sales unexpectedly fell in June, adding to speculation the Federal Reserve may opt for another round of quantitative easing to boost growth.
Traders said some of the renewed euro selling came on a Wall Street Journal report that the European Central Bank favoured imposing losses on senior bondholders of the most severely troubled Spanish savings banks. That would contrast with its 2010 position that senior bondholders in bailed-out Irish banks should not suffer losses.
The ECB declined to comment on the report.
Continued uncertainty about the Spanish banks' bailout package and expectations of further interest rate cuts by the ECB put pressure on the euro with analysts saying more losses were in store, especially against the British pound.
"Sterling is the best valued non-euro currency and it makes sense to go short euro/sterling even at these levels," said Kit Juckes, currency strategist at Societe Generale. He expected the euro to drop to 75 pence in one month.
"Sterling is pretty cheap in comparison to other European currencies like the Swedish currency even after pricing in the weakness in the UK economy and dovishness from the Bank of England."
The euro fell 0.4 percent to 78.33 pence against the pound , its weakest since November 2008. A reported option barrier at 78.25 pence was expected to be tested in coming days.
Confidence in the ability of euro zone plans to shore up Spanish and Italian markets also took a blow from Germany's top court setting a Sept. 12 deadline for a decision over whether it would block the latest version of the fund.
That means the fund will not be using the new powers granted to it by euro zone leaders last month any time soon.
UBS head of FX strategy, Mansoor Mohi-uddin, said sterling's strength against the single currency was justified as UK gilts continue to benefit from their AAA status.
He added that the UK Treasury's move to get banks to increase credit to the broader economy was likely to help shore up investor sentiment especially given euro zone policymakers were still grappling with the debt crisis.
"The UK authorities, in contrast to the laboured efforts of their euro one counterparts, are trying to deal with the impact of the credit crunch on Britain's economy," he said.
The euro's losses against sterling saw the trade-weighted sterling index rise to its highest in two months. The index rose to 84.1, its highest since May 16.
The pound also managed to gain 0.2 percent against the dollar to $1.5596, despite the International Monetary Fund slashing its UK growth forecast.
Analysts said some investors were going short of the dollar ahead of testimony from Federal Reserve Chairman Ben Bernanke on Tuesday and Wednesday in case recent poor U.S. data prompted him to hint at more monetary stimulus.
"The dollar has come off very sharply on a broad basis, that's all in the lead up to the Bernanke testimony," said Kathleen Brooks, research director at Forex.com.
"But the market may be getting a bit ahead of itself. Just because we get some weak economic data out of the U.S. does not mean the Fed will jump on the back of more quantitative easing."
Monetary easing tends to weigh on demand for the dollar because it increases the supply of greenbacks in the system.