Italy's five-year borrowing costs are expected to rise further above 6 percent on Wednesday, to mark a new euro lifetime high, at an auction that will provide a first test of bond market sentiment towards the euro zone after last weekend's EU summit.

Measures agreed by European leaders to strengthen fiscal discipline have not convinced markets the debt crisis will be resolved and threatened rating downgrades for euro zone states averted, or curbed yields on outstanding Italian debt.

Saddled with a debt equivalent to 120 percent of gross domestic product, Italy has seen its funding costs spiral towards unsustainable levels since taking centre stage in the debt crisis in early July.

The yield on the five-year BTP bond it will sell on Wednesday topped 7 percent on Monday, although it was able to sell short-dated debt on the same day at a slightly lower cost than the euro-era high levels seen a month before.

Italy paid 6.3 percent in November to sell five-year bonds, its highest cost of borrowing since the single currency's adoption in 1999.

The same September 2016 BTP bond yielded around 6.8 percent late on Tuesday as markets fretted over implementation of measures on the euro zone bailout fund agreed at the summit. Fears that credit rating agency Standard & Poor's will downgrade some or all of the 15 euro zone sovereigns it has on watch after the summit also kept investors edgy.

The small size of Wednesday's sale -- limited to just one issue of up to 3 billion euros (2.5 billion pounds) -- should help it go through despite low liquidity in the markets close to year-end. But bigger tests loom in the new year.

BIG CHALLENGE IN JANUARY

Italy has trimmed the size of its auctions in reaction to market pressure but it will have to step up issuance if it is to meet a gross funding goal of around 440 billion euros next year.

The issuance challenge for Italy in 2012 is considerable and January will provide an important first hurdle, Citi analysts said in a comment on Wednesday's auction.

Nearly 26 billion euros of BTP bonds mature on February 1, with 91 billion euros of bonds falling due by the end of April.

ECB buying in the secondary market will help, but, if the crisis worsens, it is difficult to see how Italy will retain independent market access in 2012 and help from the International Monetary Fund may at some stage be needed, Citi analysts said.

The European Central Bank has propped up Italian and Spanish government bonds though purchases on the secondary markets since early August. Analysts say its indirect support has been key in helping purchases by primary dealers at auctions because they can sell at least part of their holdings to the central bank.

With investors' portfolios closed ahead of year-end, the auction is a matter for primary dealers. Luckily they know they can count on the ECB, said a London-based bond trader.

Expectations measures to be agreed at the summit would prompt more aggressive ECB bond buying -- coupled with a new austerity package by the Rome emergency government aimed at staving off financial disaster -- had driven Italian yields lower last week.

But selling pressure returned after ECB President Mario Draghi dashed hopes the central bank would ramp up its purchases in response to the EU agreement on more stringent fiscal rules.

ECB sources told Reuters purchases would remain limited for the time being but analysts say a radical shift may be needed next year if the situation deteriorates.

Bank of Italy Governor Ignazio Visco said last week that Italian borrowing costs must fall in a sustained way to around 5 percent to ensure Rome can continue to manage its 1.9 trillion euro debt.

Spain will also sell bonds this week, with up to 3.5 billion euros of 2016, 2020 and 2021 bonds due for auction on Thursday.

It sold short-term debt on Tuesday, paying less to borrow than record levels seen at a November sale, but analysts warned good demand for its 12-month and 18-month T-bills would not necessarily translate into a bid for longer-dated paper.

This is defensive, this is balance sheet paper, there may be the odd FX reserve manager who has looked at it and picked them up ... it doesn't really tell us how the auctions on Thursday are going to go, said Marc Ostwald, strategist at Monument Securities in London.

(Reporting by Valentina Za; Editing by Catherine Evans)