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MILAN (Reuters) – Rising expectations of bolder policy moves to counter the euro zone’s debt crisis are set to help Italy sell up to 5.5 billion euros (4.29 billion pounds) in bonds at an auction on Monday, where benchmark 10-year yields will be closely watched as a barometer of market stress.

Comments by European Central Bank President Mario Draghi, who on Thursday pledged to do whatever necessary to defend the single currency, pushed Italian and Spanish yields lower at the end of last week, halting a worrying rise in the debt costs of the countries at the centre of the crisis.

The September 2022 bond which Italy will sell on Monday yielded slightly less than 6 percent late on Friday, pointing to a likely easing in funding costs for Rome after it paid a punitive 6.19 percent yield a month earlier to sell 10-year paper amid high uncertainty ahead of a European Union summit.

Extreme volatility in thin holiday markets, however, warrants caution, debt analysts said.

Italy will also sell a five-year bond due in June 2017 which on Friday was trading at around 5.4 percent – well below a level of 5.84 percent reached at an end-June sale. Up to 750 million euros of a November 2015 bond no longer sold on a regular basis are also on offer.

Italy’s 10-year yields hit their highest since January at 6.6 percent on Tuesday as investors fretted about the cost of a potential full bailout for Spain and the impact this could have on Italy.

“Draghi has managed to turn the tide, for now at least. We saw a really ugly movement in yields, especially Spain’s, early last week,” said Intesa Sanpaolo’s strategist Chiara Manenti.

Annalisa Piazza, a market economist at Newedge Strategy in London, said in a note she anticipated “rather solid” demand for bonds of stressed euro zone countries on sale this week given expectations of action by policymakers in the wake of Draghi’s comments.

Spain holds a bond auction on Thursday.

JOINT ACTION

Echoing Draghi’s pledge, on Sunday German Chancellor Angela Merkel and Italian Prime Minister Mario Monti jointly vowed to do everything to protect the euro zone and swiftly implement measures agreed at the end-June EU summit.

Merkel had expressed a similar commitment on Friday in a joint statement with French President Francois Hollande, further fuelling market expectations of swift moves to halt the rise in Spanish and Italian borrowing costs.

Analysts warn that disappointment would trigger a new bout of selling.

“I think markets have enough confidence in the ECB to give it a few days. If nothing were to happen, though, yields would start rising again,” said ING strategist Alessandro Giansanti.

Investors will be looking for indications from the ECB on Thursday, when its governing council meets to set interest rates.

Burdened with a 2 trillion euro debt pile and in the grip of a harsh economic recession, Italy has seen its debt costs track Spain’s higher as Madrid struggles to retain market access despite mounting budget troubles.

Should Madrid seek further aid after a bank bailout of up to 100 billion euros, investors’ attention would turn to Italy, whose economy is twice that of Spain’s and whose funding needs are much larger, totalling 450 billion euros this year.

Ahead of Monday’s sale, the Treasury had met 63 percent of its yearly goal. A broad domestic investor base has helped Italy cope with shrinking foreign demand for its debt.

But with domestic demand mostly geared towards shorter maturities, sales of longer-dated bonds offer a clearer picture of investors’ sentiment towards Italy. Ten-years is the longest maturity the Treasury offers on a regular basis.

The head of debt management in Italy said this month a three-year bond Rome sold in mid-July had attracted foreign interest. Traders also mentioned bids from foreign banks – for the first time in a long time – at a six-month bill sale Italy held on Friday.

Analysts say that negative yields on short-term paper of higher-rated euro zone countries may have prompted a risk reassessment by some investors.

“Treasury bills carry less risks. Monday’s sale, especially the 10-year one, will be more telling,” ING’s Giansanti said.

The Treasury’s decision to cancel a mid-August bond sale due to thin liquidity at the height of the summer season is expected to support demand. Coupon payments worth 18.7 billion euros on Italian bonds should also help, analysts said.

(Reporting by Valentina Za; Editing by Peter Graff)