(REUTERS) -- Spain and Italy spread cheer through Eurozone markets on Thursday with successful debt auctions at sharply lower borrowing costs in 2012's first real test of appetite for debt from the Eurozone's bruised periphery.

The Spanish Treasury raised 10 billion euros ($12.7 billion) from the auction of three bonds, doubling its target of up to five billion, and yields dropped by about 1 percentage point.

Italy also fared well, paying less than half what it did a month ago to sell one-year bills at its first auction of the year.

European shares extended gains in response and the euro currency rose to a session high.

Domestic banks continued to lend support thanks to ultra-cheap funding from the European Central Bank, which provided banks with nearly half a trillion euros of three-year money late last year and will make a similar offer in February.

Basically the only reason this has been taken down so well is abundant ECB liquidity and with another one coming up in February, just for now the market seems very complacent, said Michael Leister, strategist at DZ Bank in Frankfurt.

With the ECB money borrowed cheaply at just 1 percent, banks can buy government bonds with the same maturities from troubled euro zone sovereigns, exploiting the sharp difference in yields.

French President Nicolas Sarkozy has urged them to do so but until now, analysts had not expected it to amount to much.

Spain's risk premium, the spread between the yields on Spanish and German benchmark bonds, narrowed to its tightest level since January 3, to about 339 basis points from more than 354 basis points at Wednesday's close.

The 10-year yield spread between Italian and German bonds fell below 500 basis points for the first time this year.

As tactics go, it is clear that getting as much done as quickly as possible in terms of funding a deficit is wise in the current environment, said Marc Ostwald, rate strategist at Monument Securities in London.

The yield on Italian 12-month bills fell to 2.735 percent, from the near 6 percent Italy paid to sell one-year paper at a mid-December auction and marked the lowest level since June 2011.

Italy will launch its 2012 bond issuing campaign on Friday when it offers up to 4.75 billion euros of debt including its three-year benchmark and two off-the-run issues. The glut of ECB money may well give that sale a fair wind too.

TOUGH YEAR AHEAD

Spanish local media attributed the auction's success to tough cost-cutting measures announced by new Prime Minister Mariano Rajoy. His center-right People's Party retweeted a headline from rightist newspaper ABC Success for Rajoy's measures in the auction.

But analysts said politicians will remain under close scrutiny this year and questioned how long domestic banks would be willing to hold medium to longer term government debt, underlining the need for decisive euro zone-wide moves to end the crisis.

Spain still face huge challenges this year to meet tough deficit targets after the government missed its 2011 cost-cutting goal and the economy sinks into recession.

The Spanish treasury said on Wednesday it would cut net debt issuance by 26 percent in 2012. The final budget is due to be set in March.

Experts estimate Spain needs to raise about 177 billion euros gross in 2012. This compares with Italy's plan to raise 450 billion euros in gross terms, including bills and bonds.

Compared with Italy, Spain's funding needs this quarter look like a walk in the park. Right now, Spain is perceived as a safer credit than Italy, said Spiro Sovereign Strategy's Nicholas Spiro.

There have been false dawns in perceptions of Spanish risk. Spain is now in a more precarious position than a year ago given the scale of its budget deficit and the deteriorating economic outlook, Spiro said.

The new centre-right government has predicted that the 2011 deficit left by the Socialists, who lost November elections, would be much higher than expected at around 8 percent of GDP.

(Additional reporting by Tomas Gonzalez in Madrid and Valentina Za in Milan; Editing by Fiona Ortiz/Mike Peacock)

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