European shares and the euro rose on Friday on expectations debt-scarred Italy's first bond sale of the year would go well, but unease over Greece's debt swap deal and prospects for the broader euro zone economy capped gains.

The market mood was lifted on Thursday by a strong debt auction from Spain, tapping a flood of three-year loans to banks from the European Central Bank, which was cautiously optimistic on the region's outlook after leaving the door open to further interest rate cuts.

The euro has risen after (Thursday's) auctions were much better than expected,, said Manuel Oliveri, currency strategist at UBS in Zurich.

But it's only a correction so far and there's no serious fresh buying.

The euro rose 0.3 percent to $1.2824, having climbed to as high as $1.2879 in Asian trading, and pulling further away from a 16-month low near $1.2662 hit earlier in the week.

The FTSEurofirst 300 <.FTEU3> index of top European shares rose sharply at the open before easing back to a gain of 0.3 percent at 1,022.06 points by 0940 GMT. It reached a five-month high of 1,031.08 on Thursday before closing 0.3 percent lower.

Banks were the main gainers, with the STOXX Europe 600 Bank index <.SX7P> up 1.6 percent.

The MSCI global index <.MIWD00000PUS> rose 0.4 percent.

In a second key test in two days of market appetite for debt from the countries at the frontline of the euro zone crisis, Italy sells three-year bonds along with 2018 paper in an auction due at 1000 GMT.

The difference between the rates it pays compared with benchmark German bonds - a key measure of investor confidence -narrowed early on Thursday, and a successful sale could see the spread shrink further.

Italy's 10-year government bond was yielding around 6.5 percent on Friday compared to levels of around 7.0 percent before the Spanish debt auction.

Alan McQuaid, chief economist at Bloxham Stockbrokers, said he expected the auction to draw strong demand.

It wouldn't surprise me if peripherals continue to do well, especially with another three-year (ECB funding injection) coming up in February.

But the critical point is the end of the month to see what the (euro zone) policymakers come up with to improve sentiment further. Sentiment is still fragile. It has been encouraged by the actions of the ECB, but politicians have to deliver as well.

The outcome of make-or-break debt swap talks to prevent the euro zone's weakest link, Greece, from slipping into default remained in the balance.

Private sector bondholders said time was running out to seal a deal on a voluntary debt exchange, though Greek officials sounded more optimistic and French bank Societe Generale said agreement was close on a writedown of at least half the value of the debt.

Whatever the outcome, an agreement on the Greek debt swap is unlikely to be enough to bring Greece back to a sustainable path, said Oliveri at UBS.

RISK APPETITE

Another key yardstick of investor sentiment, the Euro STOXX 50 volatility index <.V2TX>, dropped 4.3 percent to touch a five-month low in early trade. At 0935 GMT it was down 3.2 percent at 0935 GMT.

Greater appetite for risk also weighed on safe haven gold, pushing it down 0.6 percent to $1,642 an ounce after it hit a one-month high on Thursday, but oil recovered from a sell-off in the previous session on a report that a proposed European Union embargo on Iranian crude imports would be delayed.

If more people become bullish, prices, particularly in equities and commodities, will rise. It's now just a matter of when you make the switch. said Tetsu Emori, a fund manager with Astramax Co. in Tokyo.

Brent crude rose close to $112 a barrel, boosted by worries over supply disruption from Nigeria, but gains capped by a report that a proposed European Union embargo on imports of Iranian crude would be phased in over six months.

On Thursday the ECB left official interest rates unchanged and did not offer to take any further action to tackle the euro-zone's debt crisis, saying there were tentative signs the economy was stabilizing.

The bank said its cheap three-year loans were helping banks and supporting morale across the euro zone.

The outcome came as little surprise to investors given the slightly firmer tone of some of the recent data and recent back-to-back rate cuts.

Italy will hope to match the success of Thursday's Spanish auction when it sells up to 4.75 billion euros of bonds on Friday.

On the data front, British factory gate inflation fell more than expected in December, official data showed on Friday, boosting expectations that the Bank of England will inject more stimulus into the struggling economy soon.

Sterling fell to a two-week low against the euro following the data.

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Asset performance in 2012: http://link.reuters.com/nyw85s

ECB bank borrowing, deposits: http://link.reuters.com/nyd85s

ECB in graphics: http://link.reuters.com/neg32s

Europe earnings expectations: http://link.reuters.com/duc95s

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(Additional reporting by Richard Hubbard and Neal Armstrong,; Editing by Catherine Evans)

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