Italian yields ease after bond auction

Italian government bond yields eased on Wednesday after the country sold 3 billion euros of five-year debt in the first longer-term auction since the European Union took steps towards greater fiscal integration last week.

The sale drew decent demand, with yields lower than those seen in the secondary market ahead of the auction, but borrowing costs were still at euro-era highs around 6.5 percent, doing little to dispel concerns about the country's longer-term financing sustainability.

Given the large concession given ahead of today's tap, we expected demand to be a touch stronger, said Annalisa Piazza, market economist at Newedge Strategy.

However, uncertainties on the future of the debt crisis remain high and the market seems to be mainly driven by flight-to-quality this morning.

Saddled with a debt equivalent to 120 percent of gross domestic product, Italy's funding costs have spiraled towards unsustainable levels since it took centre stage in the debt crisis in early July.

Secondary market yields edged lower on the week however, reversing the rise of the last two sessions seen after markets were left unconvinced by the effectiveness of the steps taken by EU leaders last week to stem the debt crisis.

Obviously 5-year funding rates of 6.5 percent are unsustainable and the cost of funding will become a crucial factor in the first quarter of next year, said WestLB rate strategist, Michael Leister.

For now however, the market is happy with the supply being digested rather than raising questions as to the price... of doing so.

The sale was likely supported by domestic investors with few other buyers of Italian bonds seen recently apart from the European Central Bank.

Investors are pulling back into their domestic markets all over the euro zone, said Rabobank rate strategist Richard McGuire.

Your government is ultimately going to be the one, that if everything else fails, supports you. You want to be holding their debt rather than be on the hook for someone else's.

Benchmark 10-year Italian yields were flat at 7.13 percent, with yields on the September 2016 bond auctioned almost 13 basis points lower on the day at 6.73 percent.

Germany sold 4.18 billion euros of two-year bonds, drawing stronger demand than at a previous sale despite yields being at euro-era lows.

Analysts said demand for liquid assets heading into year-end supported the sale, along with an 18 billion euro Schatz redemption due on Friday.

German Bund futures rose, with equity markets in negative territory, after the U.S. Federal Reserve announced no fresh stimulus measures. The risk of a mass downgrade of euro zone countries' credit ratings, after a Standard & Poor's warning last week, also underpinned sentiment.

March Bund futures were 35 ticks higher at 136.95.

Activity has dropped sharply as year-end approaches with volumes dwindling to less than 500,000 lots over the last week, almost half the daily trading seen in recent months.

UBS technical analysts Richard Adcock said that the contract needed to break above the 62 percent retracement of the November sell-off at 137.22 in order to extend gains to 137.95.

Two-year bond yields were a basis points higher at 0.29 percent, with 10-year yields at 2.01 percent.

(Reporting by Kirsten Donovan, editing by Nigel Stephenson; John Stonestreet)