* Italian debt rises after previous day's sell-off
* Decent demand expected at Thursday's Italian bond sale
* 10-year Bund yields seen stuck in 2.10-1.6 pct range
By Ana Nicolaci da Costa
LONDON, March 28 Italian government bonds rose on Wednesday after a sharp sell-off in the previous session, with good demand at a sale of six-month Italian bills providing a favorable backdrop for a bond auction on Thursday.
Analysts expected the flood of liquidity in financial markets to favor the sale of five- and 10-year paper on Thursday, especially given a cheapening of bond prices following an auction of inflation-linked bonds in Rome that triggered selling the prior day.
Markets were expected to be stuck in a range as investors digested a patchy run of data, with many also fearing that fiscal slippage in Spain or problems pushing Italian labor reforms through parliament could lead to another flare-up.
"Italy saw quite a big sell-off yesterday by recent standards," Nick Stamenkovic, strategist at RIA Capital Markets said, adding today's move was probably a correction.
"It will be difficult for Italian bonds to rally (further) ahead of the auction tomorrow, and while uncertainty persists over the outcome of the labor market reform."
Italian Prime Minister Mario Monti opted on Friday not to rush the heavily contested reform through parliament after running into strong resistance from unions and a key ally supporting his government.
Italian 10-year bonds rose, with yields falling 7.3 basis points to 5.07 percent.
Italian six-month borrowing costs fell further towards 1 percent on Wednesday, marking their lowest level since September 2010, as a bill auction drew good demand ahead of Thursday's bond sale.
Spanish 10-year yields were down 5.9 bps at 5.30 percent.
Italian bonds were the worst performers in the euro zone on Tuesday after an inflation-linked bond auction inspired investors to take profit on Italy's recent outperformance over Spain ahead of the end of the quarter.
"Yesterday we saw quite a pronounced underperformance versus Spain which is more likely due to the supply and gradually it is becoming tougher for the Italian Treasury to sell the paper now that the LTRO (long-term ECB refinancing operation) effect is slowly fading out," Michael Leister, strategist at DZ Bank said.
But he expected the Italian auction on Thursday to attract decent demand: "On the one hand there is price concession and on the other hand (there is) still the old story of domestic support, basically the liquidity effect which is not as strong as it was in the first two months, but it is still out there."
The German Bund future was up 13 ticks at 137.44 in choppy trading that saw it drop in and out of negative territory. Ten-year German bond yields were little changed at 1.88 percent, roughly the middle of the current 2.10-1.60 percent range.
"I think we are waiting for the next blow-up ... I think Europe is massively complacent in thinking they have solved everything," a trader said.
Investors will also sift through a flurry of data from the United States this week, with durable good orders later in the day being followed by growth and inflation numbers on Thursday.
Recent comments by Federal Reserve chief Ben Bernanke fueled investor bets for further monetary stimulus.
Bernanke said on Tuesday it was too soon to declare victory in the U.S. economic recovery, warning against complacency in policymaking as the outlook brightens.
In a speech on Monday, he said the U.S. economy would need to grow more quickly to ensure continued progress in reducing the jobless rate.
"The market seems to be struggling for direction. Bund yields at these levels don't look attractive," Stamenkovic said, adding the U.S. data would provide some guidance.