(Adds detail, updates prices)
* Euro flat, investors wary of big bets ahead of U.S. jobs report
* ECB steps, expectations of bank recapitalisation support euro
* Moody's downgrades UK banks but sterling/dollar firm
By Anirban Nag
LONDON, Oct 7 (Reuters) - The euro paused in its climb against the dollar on Friday as investors were hesitant to add to the single currency's upside before U.S. jobs data, following its rally after the European Central Bank provided liquidity to struggling euro zone banks.
Traders said the euro was still a sell on rallies with a good deal of scepticism over the bloc's ability to pull together a swift response to the sovereign debt and banking crisis.
"Some of the euro/dollar shorts have been squeezed as the market seems to be taking the positive aspects from the ECB measures and hopes of recapitalisation of European banks," said Paul Robson, currency strategist at RBS Global Banking.
"Going into the U.S. jobs data, a very weak number could see the euro drop while a consensus to marginally weak number could help."
September's U.S. payrolls report, due at 1230 GMT, is expected to show 60,000 new jobs created and the unemployment rate unchanged at 9.1 percent. The numbers will be scoured for signals on whether the U.S. economy is headed for recession.
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Graphic on U.S. payrolls http://link.reuters.com/qen34s
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The euro was flat on the day at $1.3425 , well off a nine-month low of $1.3145 on Tuesday and on track for its first weekly gain in three.
It rose 0.6 percent on Thursday after the ECB announced new 12- and 13-month lending operations as well as a plan to buy 40 billion euros of covered bonds, which will probably tide banks over through 2012.
The single currency rose as high as $1.3464, but gains were capped by stop-loss orders cited above $1.3470 and $1.35.
Traders say a hefty $2 billion in $1.3400 options are set to expire later in the day, along with $1 billion at $1.3500, which may keep the euro hemmed in between those levels.
Though the ECB stopped short of cutting rates as some had speculated, the measures were enough to lift stocks and commodities as risk appetite showed some signs of stabilising.
Indeed, Morgan Stanley said it had changed its short-term strategy and planned to buy pro-cyclical currencies like the Australian dollar and the euro over the next few days to take advantage of the corrective rebound.
In a note, its analysts argued that short positions in the euro were at an extreme and there was potential for a correction, although they remain bearish in the medium term.
Any correction may prove temporary as many players doubt that a pan-European policy action on banks will come quickly, given the euro zone's history of struggle in gaining a consensus among member states.
The options market shows implied volatility for euro/dollar has slipped in the past week, suggesting investors had priced in more volatility stemming from euro zone risks than the U.S. payrolls data.
One-month implied vol slipped to around 15.5 percent from around 16 percent the previous day.
Meanwhile, one-month 25-delta risk reversals, which gauges the skew between bets to buy or sell the euro, were unchanged at levels which indicate the market remains tilted towards more euro weakness.
UK BANKS DOWNGRADE
Analysts were cautious about whether a positive payrolls surprise could provide lasting support to risky assets.
In an environment where more banks are cutting global growth forecasts and some even expect a fresh recession, the safe-haven dollar and the yen would be preferred.
"It will take a really negative payrolls data for the risk-off trade to return," said Geoff Kendrick, currency strategist at Nomura. "Market pricing of a financial Armageddon has been pared back after yesterday's ECB measures, but structurally the euro could still head back towards multi-month lows."
Sterling was in the spotlight, gaining against the dollar and the euro with currency investors largely ignoring a Moody's downgrade of some large UK banks. The ratings cut came a day after the Bank of England announced more quantitative easing.
Sterling rose 0.5 percent to $1.5505 , having dived to its lowest level in 14 months against the dollar at $1.5270 on Thursday after the BoE decision.
The Australian dollar rose 0.3 percent to $0.9774 , pulling back from a session high as European shares pared earlier gains.
The dollar was flat at 76.66 yen while the euro was marginally softer at 102.95 yen . The yen barely moved after Bank of Japan kept monetary policy on hold.
Governor Masaaki Shirakawa said the yen's rise was having a huge impact on the economy, keeping alive the risk of solo intervention by the Japanese. . (Additional reporting by Naomi Tajitsu; Graphic by Scott Barber; Editing by Nigel Stephenson/Toby Chopra)