Italy's borrowing costs dropped sharply as it sold the maximum amount of 5 billion euros at an auction of short-term debt on Thursday, helping drive down yields on its longer-dated bonds ahead of a crucial sale of five- and 10-year paper on Monday.

At the first auction since credit rating agency Standard & Poor's downgraded Italy by two notches, yields on its two-year zero-coupon bonds fell to 3.76 percent - the lowest since August and more than a percentage point less than it paid a month ago.

The Treasury managed to sell at the top of the range and at a lower yield, said Sergio Capaldi, an analyst at Intesa Sanpaolo in Milan.

We are returning to (yield levels seen) last summer but we still have a long way to go before the situation normalizes. A year ago yields were below 3 percent.

Italian government bond yields and the cost of insuring its debt against default fell after the auction, with the yield on its benchmark 10-year bond 15 basis points lower on the day at 6.09 percent.

The cost of a five-year credit default swap fell 29 bps to 410 bps, according to prices from Markit.

S&P cut Italy's rating to BBB+ with a negative outlook on January 13, citing rising external financing risks.

Italian bond yields have nevertheless fallen from euro-era highs hit in November as cheap European Central Bank loans have fuelled appetite for its short-term debt among domestic banks.

But longer-dated bonds have rallied less, and Monday's sale of up to 8 billion euros is considered an important test of demand for Italian paper among international investors whose support it will need to meet this year's huge borrowing target.

Uncertainty over the outcome of talks between Greece and its private sector creditors on a debt restructuring it needs to avoid a messy default is complicating efforts by Rome to refinance some 90 billion euros of bonds maturing between February and April.

Monday's auction settles on February 1 when nearly 26 billion euros of BTP bonds and around 10 billion euros of coupon payments fall due.

On Thursday, Italy sold 4.5 billion euros of the new January 2014 CTZ bond. It also sold 500 million euros of an off-the-run September 2014 BTPei last auctioned in 2005.

Citi warned in a note that another two-notch downgrade of Italy expected from rating agency Moody's would mean BTPei bonds are excluded from a major inflation index, which is likely to trigger selling by accounts that automatically replicate the composition of the index.

However, once this event has passed, and the market has re-priced accordingly ... the index event may create buying opportunities, although these are still likely to be confined to the short-end, Citi analyst Jamie Searle said in the note.

Both zero-coupon and inflation-linked bonds fall outside the scope of purchases carried out by the ECB on the secondary market in a bid to support Italian debt.

On Friday, Italy will also sell 8 billion euros of six-month bills and 3 billion euros of one-off bills maturing at the end of December.

Rome has said it plans to take advantage of stronger demand for shorter-dated debt in the first half of this year but is aware that significantly shortening the average life of its debt from around seven years would undermine a major credit strength - as S&P warned in its rating statement.

(Editing by Catherine Evans)