Italy debt costs to fall at auction, Moody's cut eyed

MILAN (Reuters) - Italy's three-year borrowing costs will dive compared to a month ago at an auction on Tuesday as cheap ECB loans continue to support demand for government paper, although the latest in a round of credit ratings cuts may put some pressure on yields.

Rome will contribute to a heavy schedule of euro zone supply this week by offering up to 6 billion euros of bonds, including its November 2014 three-year benchmark and two off-the-run issues due in November 2015 and February 2017.

The downgrade of Italy by ratings agency Moody's may add to market nerves ahead of the sale after a T-bill auction on Monday saw unusually low demand which could suggest diminishing appetite from investors in the face of falling yields.

But the cut in the sovereign rating to 'A3" was widely anticipated and also followed moves by Standard & Poor's and Fitch Ratings last month which were broadly shrugged off by markets. Analysts said on balance it should not undermine Tuesday's auction.

"Moody's rating for Italy is still higher than S&P's 'BBB+'," said ING strategist Alessandro Giansanti.

"At 375 basis points, Italy's 10-year yield spread against Germany implies a rating lower than 'BBB', so I don't expect a big impact from the Moody's decision," he said.

Demand for government paper that can be used to borrow cheaply from the European Central Bank has driven Italian short-term yields sharply lower after the central bank flooded markets with half a trillion euros of three-year funds in late December.

Traders warn that yields may not have much further to fall from current levels, but they say demand is still robust ahead of a second ECB tender on February 29 at which banks are expected to grab another 500 billion euros of ultra-cheap loans.

Italy has stepped up its issuance of short-term debt to take advantage of the surge in demand for these less risky maturities as it strives to refinance some 90 billion euros of bonds expiring between February and April. It has already sold nearly 30 billion euros of bonds at auctions settled in 2012.

The yield on Italy's November 2014 BTP bond rose by around 8 basis points early on Tuesday to 3.58 percent, but that still points to a significant drop in three-year funding costs. At a sale in mid-January it averaged 4.8 percent.

Analysts said the three-year benchmark was still attractive compared to bonds of similar maturity on the Italian curve but warned the Treasury may cut the sale below the maximum planned amount of 4 billion euros, a significant size for a single bond.

On Monday Italy's one-year borrowing costs fell again at auction despite weak demand, which left the auction only just covered.

The Bank of Italy said the unusually low demand for one-year bills might have been due a to a technical glitch delaying some bids until after the submission deadline. [ID:nL5E8DD2HI]. If that proves not to be the case, Monday's auction results could add to evidence showing demand is becoming strained, analysts said.

The costs of refinancing Italy's 1.9 trillion euro debt pile started rising in the second half of 2011 and reached a peak in November before tumbling after the ECB's three-year tender.

Spanish short-term borrowing costs are also expected to edge down on Tuesday, when Madrid offers 5.5 billion euros of 12- and 18-month bills ahead of a three-year bond sale on Thursday.

Greece will also sell three-month bills on Tuesday, while Belgium will offer three- and 12-month paper.

Italy will also face competition on Tuesday from the Netherlands, one of the euro zone's top-rated countries, which will issue up to 4 billion euros of five-year bonds.

(Additional reporting by Nigel Davies in Madrid; Editing by Patrick Graham)