bundsMILAN: Italy is set to pay lower yields when it sells up to 6.5 billion euros of bonds on Thursday, with growing optimism that European leaders are responding more effectively to the euro zone debt crisis outweighing two rating downgrades in less than a week.

Moody's and Fitch cut Italy's credit-ratings last week after the euro zone's third-largest economy took centre stage in the crisis this summer due to its towering debt pile and ailing growth rates.

Expectations that a deal will be reached to expand the euro zone's rescue fund and that European leaders will hammer out a recapitalisation plan for the region's banks has won Italy some respite on the markets this month after its bond yields soared to near unsustainable levels.

Italian bonds have also been helped by purchases from the European Central Bank, which started in August, although even that has failed to keep a lasting lid on yields.

The average rate on the five-year BTP bond on sale on Thursday is seen falling to around 5.25 percent from 5.60 percent a month ago -- broadly in line with secondary market levels on Wednesday. The bond has weakened ahead of the sale.

Despite the fall, yields remain far from levels seen as comfortable over the long term for the sustainability of Italy's 1.9 trillion euro debt. In mid-June, before the start of a market sell-off of Italian assets, the auction yield on the five-year BTP was 3.9 percent.

"For now Italy will continue to pay high yields. This is sustainable for some time, and offers the country some wiggle room to tackle its structural problems," said Matteo Regesta, a strategist at BNP Paribas in London.

Complicating the situation for Italy is its high political uncertainty, with Prime Minister Silvio Berlusconi expected to face a confidence vote this week after his centre-right government lost a key vote in parliament.

Analysts said the government was unlikely to fall immediately but its ability to take action would be constantly hampered by internal disputes.

They added at present the European agenda took precedence over domestic developments -- though these may stoke volatility.

"What's driving markets higher are European authorities' plans for banks' recapitalisations," said Intesa Sanpaolo fixed-income analyst Chiara Manenti. "It would be dangerous if what's been promised failed to materialise."

France and Germany have said they will unveil a comprehensive crisis package at a summit delayed until Oct. 23.

On Thursday, Italy will offer up to 3.5 billion euros of the 2016 bond and up to 3 billion euros spread over three bonds maturing in 2018, 2021 and 2025 which the Treasury has stopped selling on a regular basis.

For the first time since mid-July Italy will sell a 15-year bond -- a longer maturity than the five- to ten-year area that traders say has been targeted by European Central Bank's purchases.

Italy plans to issue around 75 billion euros in the last quarter of the year, roughly equally split between short-tem bills and bonds.

Copyright Reuters, 2011

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