* Euro drops to fresh 3-1/2 year low vs sterling
* Trade-weighted sterling at 2-month high
* UK inflation, retail sales data to be eyed this week
By Anirban Nag
LONDON, July 16 (Reuters) - Sterling rose to a 3-1/2 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.
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 be a contrast to 2010 when it took a position that senior bondholders in bailed out Irish banks should not suffer losses.
The ECB declined to comment on the report.
The continued uncertainty about the Spanish banks' bailout package along with expectations of further interest rate cuts by the ECB was putting pressure on the euro and analysts said 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 expects the euro to drop to 75 pence in one month.
The euro fell to 78.55 pence against the pound, its weakest since November 2008. It was last at 78.65 pence, steady on the day, with reported option barriers at 78.50 pence and 78.25 pence likely to tested in coming days.
Confidence in the ability of the euro zone's rescue 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.
Investors fleeing those troubles have bought currencies of countries backed by solid public finances like the Swedish, Norwegian and Danish crowns given that the Swiss National Bank has put a cap on the Swiss franc's gains.
"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," said Societe's Juckes.
UBS head of fx strategy, Mansoor Mohi-uddin, said sterling's strength against the single currency was entirely justified as UK gilts continue to benefit from their AAA status.
He added 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 eurozone counterparts, are trying to deal with the impact of the credit crunch on Britain's economy," he said.
Investors remain bearish about the euro due to the currency bloc's festering debt crisis, a decision by the ECB to lower the deposit rate to zero and slowing global growth.
Last week Moody's cut Italy's credit rating by two notches to Baa2 late and warned that further cuts could be on the cards if Italy's access to debt markets dried up.
The euro's losses against sterling saw trade-weighted sterling index rise to its highest in two months. The index rose to 84.1, its highest since May 16.
Despite its gains versus the struggling euro, the pound was 0.2 percent lower against the dollar, trading at $1.5544 . Traders said the currency was vulnerable to losses against the U.S. currency if worries grow about the euro zone.
While sterling is preferred over the euro, the British pound tends to suffer against the dollar as the UK has sizeable exposure to the euro zone through trade and financial links.
The UK will publish inflation, jobs and retail sales data this week.. Private sector housing market data are also providing renewed bearish signals.
Late last week data showed construction output dropped 6.3 percent year-on-year in May, adding to concerns Britain may have contracted for a third consecutive quarter between April-June.