* Bund futures at five-week lows on ECB, Spain sale * Strong Italy debt sale could keep Bunds in retreat * Three-yr Italian borrowing costs set to fall at auction By Emelia Sithole-Matarise LONDON, Jan 11 (Reuters) - German Bund futures fell to five-week lows on Friday, extending losses after the European Central Bank dampened prospects of an imminent rate cut and gave a slightly more upbeat view of the euro zone's economic outlook. The sell-off in the region's lowest risk debt could gain momentum with Italy expected to draw strong demand at a bond auction later in the day, following Spain's successful start to its 2013 funding programme on Thursday. Bunds resumed last week's falls, propelling German two-year yields to their highest level since October, after ECB President Mario Draghi said policymakers were unanimous in holding interest rates steady at their meeting on Thursday, easing pressure for the bank to cut rates soon. He also said the economy would recover later in 2013 and there were some signs of stabilisation. "Yesterday the market was pricing out any near-term rate cuts and the periphery had a good day so it's all negative for Bunds," a trader said. The Bund future was 35 ticks lower on the day at 142.36, its lowest since early December and adding to Thursday's fall of nearly one point. "The Italian auction is pretty small so it will go well so presumably Italy and the periphery will remain supported so things might be a bit fragile for Bunds." the trader said. German 10-year yields were 3 basis points higher at 1.59 percent while two-year yields were up 1 basis point at 0.11 percent, their highest since late October. The trader and some strategists said the return in two-year yields into positive territory could lure back some investors into the front end of the German curve, given that official interest rates are set to remain at historic lows for an extended period. "Draghi's comments saying the decision on rates was unanimous and there was no debate on rate cuts is a significant change from December. But the door is not completely closed to further rate cuts but the market has to reassess the situation," said Patrick Jacq, a rate strategist at BNP Paribas. In higher yielding euro zone bonds, Italian yields held steady before an auction of up to 3.5 billion euros of its 2015 bond and up to 1.5 billion euros of two five-year floating rate CCTeu notes. Borrowing costs for the three-year paper are expected to fall below 2 percent to levels last seen in March 2010, benefiting from the improved demand for lower-rated debt since mid-2012 after the ECB pledged to do whatever it took to save the euro followed up by a new bond buying scheme. Spanish 10-year yields were also unchanged on the day at 4.92 percent, having fallen the most in a day in nearly three months on Thursday after a strong bond auction.