Italy's cost of borrowing over six months sank towards 1 percent at an auction on Monday, the lowest in 17 months, as cheap loans from the European Central Bank fuelled banks' interest in lending to euro zone governments over the short-term.

The auction offered some measure of the progress officials have made in easing the pressure on the bloc's third largest economy, lifting prices of Italian bonds ahead of a more challenging funding test on Tuesday.

It is a very good result, said Matteo Regesta, a strategist at BNP Paribas in London. The dynamics for the 10-year sale are different ... (and) results could be less spectacular at the longer end of the curve, but the test could not come at a better time.

This week's auctions come just ahead of a second offer of cheap three-year funds for banks from the European Central Bank on Wednesday. The first sale in December turned the tide, at least for a moment, in Europe's efforts to halt the debt crisis.

The cost of financing public debts in Italy, Spain and other countries still in the firing line has fallen in response.

On Monday, the Italian Treasury sold 12.25 billion euros of bills, paying only 1.2 percent to sell six-month paper - the cheapest since September 2010. The six-month auction rate stood just below 2 percent a month ago.

Italian six-month borrowing costs remain higher than a 0.78 percent yield Spain paid earlier this month on the same maturity - reflecting Rome's much higher funding needs compared with Madrid's.

On Monday top-rated euro zone borrower Germany paid returns of only 0.08 percent to sell bills maturing in February 2013.

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ECB fuelled domestic demand has driven short-term Italian and Spanish yields sharply lower since the first three-year tender on December 21, where Italian banks took 116 billion euros or nearly a quarter of the total. Banking sources told Reuters last week Italian lenders are expected to roughly match previous demand at the new ECB offer.

Italian six-month borrowing costs hit a euro lifetime record high of 6.5 percent in late November - the peak of the euro zone debt crisis - only to halve at an auction held a month later just after the first ECB tender.

While efforts by the new Italian government have also helped improve market confidence in the euro zone third-largest economy, investors remain warier of financing Italy's 1.9 trillion euro debt over the longer-term.

Yield-hungry buyers are being squeezed up the curve where fundamentals start to matter a lot more, said Nicholas Spiro at Spiro Sovereign Strategies. There's still insufficient demand, particularly from foreign buyers, for longer-dated bonds given the increased risks.

Italy's austerity drive amid the debt crisis pushed the economy into a severe recession in the second half of last year and output is set to shrink by 1.3 in 2012 according to European Commission forecasts.

In a bid to exploit demand for short-term debt, Italy has stepped up issuance of bills this year, in the face of some 90 billion euros of bonds maturing between February and April.

Monday's auction bring the inflow from bill sales this year to nearly 26 billion euros net of redemptions. Gross bond issuance stands at around 40 billion euros ahead of Tuesday's sale for up to 6.25 billion euros.

(Additional reporting by Elvira Pollina and Giulio Piovaccari)

Germany BNP Paribas