Troubled borrower Italy tests investor appetite for its longer-term debt for the first time this year on Friday, seeking to sell up to 4.75 billion euros of bonds and match the success of Thursday's Spanish bond sale.
Domestic demand fuelled by cheap European Central Bank funds, which helped Spain sell twice the planned amount of bonds on Thursday at lower rates, is expected to drive Italian three-year costs down at the sale.
"All eyes will be on the BTP auction to see if the strong demand evident at the Spanish auction can be repeated," Citi analysts said in a note.
Citi said the market would digest the sale relatively easily but that demand was unlikely to be as strong as for Spain.
Italy will sell up to 3 billion euros of its three-year benchmark maturing in November 2014 and two off-the-run issues due in July 2014 and August 2018.
The November 2014 BTP bond yielded around 5.10% late on Thursday, and traders said they expected Friday's auction rate to be lower than the 5.62% seen in December. By comparison, the three-year auction yield had soared to a euro lifetime record of 7.89% at the height of the euro zone debt crisis in November.
Italy benefited from the ECB's liquidity boost at a bill sale on Thursday where its one-year borrowing costs more than halved compared to a month earlier.
Italian bonds rallied on the secondary market, pushing the 10-year yield gap between Italian and German bonds below 500 basis points for the first time this year.
However, Rome faces a challenging funding task in 2012 and attention will soon turn to a tougher five- and 10-year sale scheduled for January 30.
Some 90 billion euros of Italian bonds are due to mature between February and April - more than the 86 billion euro Spanish target for medium and long-term issuance in the whole of 2012.
"As long as Italy remains the focal point for investor anxiety about the euro zone, it will remain under pressure at its auctions," said Nicholas Spiro at Spiro Sovereign Strategy.
Fitch Ratings said on Thursday there was a "material risk" it would downgrade Italy by the end of the month but expressed confidence the government would be able to raise what it needs on debt markets, albeit at a cost.
Investors have been demanding higher yields to finance Italy's 1.9 trillion euro debt since the country took centre stage in the debt crisis.
Longer-term Italian debt remains a risky bet without a solution in sight to the debt crisis.
But one-year debt costs fell on Thursday to their lowest since June - before a sell-off of Italian assets began in early July - and analysts say Italy may shift part of its refinancing burden to the short term in the first part of the year.
A new three-year ECB tender in February may boost domestic banks' demand for higher-yelding government paper they can use to borrow from the ECB.
"A partial shift to the short end could help, but Italy will still need to sell five- and 10-year bonds and it will need foreign investors to buy them," said ING analyst Alessandro Giansanti.
The well-bid sales on Thursday drove Italian bond yields sharply lower on the secondary market.
"The positive price action (on Thursday's morning) bodes well, especially given anecdotal evidence that non-domestic investors are participating," Citi analysts said.
That was the first bond auction held since the ECB's first-ever auction of three-year funds on December 21 and marked an improvement after fears of a financial collapse pushed Italian three-year yields towards 8% in November.
Italy's Treasury is now better placed to refinance more than 90 billion euros of longer-term bonds maturing between February and April, but analysts warn that tensions could easily reignite in the absence of conclusive progress in solving the euro zone debt crisis.
