Italy's short-term debt costs halved at auction Wednesday as a new austerity package and an injection of cheap long-term money from the European Central Bank won Rome some respite in thin year-end markets.
But analysts warned that market nerves could easily reignite and pointed to a tougher test Thursday, when Italy will sell up to 8.5 billion euros ($11.1 bln) of longer-term bonds, including three- and 10-year paper.
Still, the lowest six-month auction yield and strongest bid-to-cover ratio since September added to a sense that some of the tension around the countries now at the center of Europe's debt problems had eased for a moment.
The outcome provided a temporary boost to European stocks <.EU> and the euro. Caution returned later in the session pushing Italian bond yields higher ahead of Thursday's sale.
This is the first piece of good news for Italy's bond market since the crisis erupted (for Rome) in July, said Nicholas Spiro of Spiro Sovereign Strategy.
While today's auction was supposed to be the less challenging of this week's two sales given the shorter maturity of the debt on offer and the predominantly domestic buyer base, it's still a success.
Italy paid an average rate of 3.25 percent to sell 9 billion euros of six-month BOT bills, down from a euro lifetime record of 6.50 percent just a month earlier. It also sold 1.7 billion euros of 24-month, zero-coupon bonds, near the low end of its target range. The yield fell to 4.85 percent, from 7.8 percent a month ago.
Since then the ECB has flooded euro zone banks with almost 500 billion euros of longer-term liquidity and the Rome government has overcome internal opposition to a radical pension reform as part of Italy's third budget package since the summer.
Spain's six-month debt costs also more than halved to 2.4 percent at an auction on the eve of the ECB's bumper tender for three-year money on December 21.
Many things have changed from a month ago, an Italian bill trader said. This doesn't mean we can rule out further problematic auctions. Markets are easily unnerved.
Doubts about how much of the ECB money would find its way to troubled government bonds have weighed on Italian and Spanish yields and investors are mindful that Rome must refinance some 91 billion euros in bonds in the first four months of next year.
Italian 10-year yields reversed an earlier fall to climb back above 7 percent in the afternoon, ahead of Thursday's auction. That pushed the premium over safer German Bunds above 500 basis points in thin trading.
While Rome can count on healthy appetite from domestic retail investors for short-term bonds and bills, longer-term debt sales are a better measure of underlying interest from external buyers.
Demand for short term paper is good. It remains to be seen whether this extends to the longer maturities, said Credit Agricole strategist Peter Chatwell.
Italy paid a euro lifetime record high yield of 7.56 percent to sell 10-year bonds at the end of November and even more to sell three-year paper in a sign of the nervousness in the market.
Traders say that the ECB targets maturities only up to 10-years in its bond buying program, further limiting the appeal of longer term Italian issues for primary dealers.
Standard & Poor's - which is expected to release its eagerly awaited verdict on debt ratings for 15 euro zone countries in January - has warned that the first quarter of next year will be tough, especially for Italy.
In a push to regain market confidence, Italy's parliament gave the final seal in the run-up to Christmas to an emergency austerity budget rushed through by a new technocrat government.
Market attention has now turned to the reform agenda of Prime Minister Mario Monti who has promised to tackle Italy's chronic low-growth problems - after inaction by former PM Silvio Berlusconi pushed the country to the brink of financial disaster.
Italy needs some breathing space to implement its reforms. Yet market pressures are set to intensify in the coming weeks given the large amount of debt falling due in the first quarter alone, Spiro said.
Monti has convened a cabinet meeting Wednesday to outline his plans and he could provide some indications to investors in his traditional year-end press conference Thursday.
Analysts expect Monti's 33 billion euro austerity package to further harm Italy's weak internal demand, making efforts to revive growth through a series of long-delayed liberalisations even more crucial.
Totaling more than 15 billion euros, demand for the BOT bills equalled nearly 1.7 times the amount of offer and was also much larger than BOT redemptions Totaling 8.8 billion euros.
(Additional reporting by William James in London; editing by Patrick Graham)