* Borrowing costs set to rise at Italian auction * Near-term sentiment may improve if demand is high * Underlying concerns over euro periphery are strong By Marius Zaharia LONDON, April 12 (Reuters) - Italian government bond yields pulled back from high levels on Thursday ahead of a debt auction expected to draw enough demand for investors to shrug off concerns the country's debt problems could spiral in the near term. Markets are positioned for borrowing costs to rise sharply at the sale of up to 5 billion euros of bonds after yields at a one-year Italian bill auction doubled on Wednesday compared with mid-March. That means the size and acceptance level of bids will be key. For Italian yields to continue falling after the auction, "markets have to see the auction was covered at least 1.5 times, the yield levels better than the secondary market ... and the amount issued reaching the maximum target," ING strategist Alessandro Giansanti said. He expected these conditions to be largely met as the recent rise in Italian yields should draw solid demand, mainly from domestic investors. This could bring the Italian/German 10-year yield spread closer to the bottom of the 340-400 basis point near-term range that Giansanti forecasts. Having risen by more than half a percentage point since mid-March, 10-year Italian bond yields fell 3.5 basis points to 5.506 percent on Thursday, narrowing the spread over benchmark German Bunds to 381 points. But with doubts growing that fellow euro zone peripheral struggler Spain can hit its fiscal targets without choking off much-needed economic growth, any relief for Italian yields following Thursday's auction is likely to be brief "The underlying picture is still very fragile, investors are still nervous about Italy and Spain," RIA Capital Markets bond strategist Nick Stamenkovic said. Spanish 10-year yields were 2.7 bps lower at 5.85 percent and are expected to underperform their Italian counterparts in the near term. A disappointing result at the Italian auction might push Spanish yields above the key 6 percent level, traders said. BOND-BUYING ON HORIZON? The recent rise in Spanish and Italian yields may increase pressure on the European Central Bank to re-activate its bond-buying programme (SMP). ECB Executive Board member Benoit Coeure said on Wednesday that the scale of market pressure on Spain was not justified given the reforms it has laid out, adding that the SMP was still an option. But analysts said the tool might have lost some of its credibility. "The SMP won't be causing a U-turn," Societe Generale strategists said in a note. "(It) has been on and off, and no longer looks like a tool that can durably affect market conditions - unless the ECB radically changes its communication and commitment." They also said that the ECB's move to avoid taking losses on its Greek bonds made investors believe they will always be subordinated to the central bank and more bond purchases could exacerbate those concerns. German Bund futures were slightly higher at 139.89, with 10-year cash yields steady at 1.69 percent. Credit Agricole strategists said a strong Italian auction could push Bund yields towards a 1.8-2 percent range.

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