* Moody's cuts Italy by two notches to Baa2, two levels above junk
* Says could cut further, warns of political instability
* Italy 3-yr yields fall well below 5 pct at auction
* Italy sells maximum planned amount in bonds
Italian banks came to the rescue on Friday after the country suffered a ratings downgrade, but while Rome cut its three-year borrowing costs at auction, a rise in 10-year bond yields highlighted concern it may fall victim to Europe's debt crisis.
Moody's cut Italy's sovereign debt rating to Baa2 on Friday, citing doubts over Italy's long-term resolve to push through much-needed reforms and saying persistent worries about Spain and Greece were increasing its liquidity risks.
Solid domestic demand helped the Italian Treasury sell the top planned amount of 5.25 billion euros in bonds, paying less than a month ago on three-year paper.
"This was a challenging enough auction without the downgrade which makes the result look all the more impressive," said Spiro Sovereign Strategy Managing Director Nicholas Spiro.
"Once again, the Treasury was able to get its debt out the door, which right now is the overriding priority."
A new 2015 bond was sold at an average 4.65 percent rate, compared with the 5.30 percent Italy paid in June just before a cliffhanger Greek vote that had stoked fears of a euro exit and soon after an unconvincing first deal to help Spanish banks.
Italian banks' commitment to support Rome's refinancing of its 2 trillion euro debt and a broad domestic investor base have provided a safety net for Italy throughout the crisis.
Foreign investors' reluctance to hold Italian debt, however, keeps the yields under pressure. Benchmark 10-year-bond yields were up nine basis points around 6 percent while Italy's debt insurance costs also rose.
"Does it mean this puts a cap on the rise in Italian yield? Well, not really," said strategist Marc Ostwald at Monument Securities in London.
The U.S. rating agency lauded Prime Minister Mario Monti's commitment to fiscal reforms and structural consolidation. But warned it could again cut the country's marks if the next Italian government failed to continue along this path.
"The negative outlook reflects our view that risks to implementing these reforms remain substantial. Adding to them is the deteriorating macroeconomic environment, which increases austerity and reform fatigue among the population," it said.
"The political climate, particularly as the spring 2013 elections draw near, is also a source of implementation risk."
Analysts say political uncertainty ahead of elections is the main risk for Italy, where frustration with austerity measures and the country's weak and fragmented party system is stoking anti-European sentiment and has helped the meteoric rise of the populist Five Star Movement, led by comedian Beppe Grillo.
Respected technocrat Monti, who was called in last November to pull back Italy from the edge of the cliff and avoid a Greek-style debt crisis, has said he will stand down next year.
Three-times Prime Minister Silvio Berlusconi, who has kept a low profile since being forced out to leave room for Monti, announced this week he will return to frontline politics as the centre-right candidate, further muddling the political outlook.
He has taken an increasingly anti-European tone in recent public comments, criticising Monti's austerity policies and openly questioning the value of remaining in the euro.
"Berlusconi seems to have picked up on the increased sense of frustration within the Italian society that the sacrifices being made by the country are not being sufficiently recognised by the markets and that part of the blame lies in the slow EU policy response," said BNP Paribas analyst Luigi Speranza.
Opinion polls suggest that a centre-left bloc would win the elections and it is not yet clear whether Berlusconi's return to front line politics may alter the picture.
The stark warning from Moody's, which comes as investors are already fretting about Spain's ability to mend its banking sector, knocked the euro down about a quarter of a cent overnight and initially sunk Italian bond futures.
The downgrade prompted angry reactions in Italian political and economic circles, with Italian Industry Minister Corrado Passera calling it "altogether unjustified and misleading."
The European Commission, which has so far mostly refrained from commenting on rating actions on individual euro zone countries, queried the timing of Moody's downgrade while backing the steps Italy has taken address its structural weaknesses.
"I do think one can legitimately and seriously question the timing of it, whether the timing was appropriate," Commission spokesman Simon O'Connor told a regular briefing.
But one senior Italian banker who declined to be named said the rating action could also provide a positive stimulus for a rapid response to the euro zone crisis: "It will create further pressure at EU level for a solution."
Italian magistrates are currently investigating for possible market manipulation past downgrade actions by the three main international rating agencies - Moody's, Standard & Poor's and Fitch - which triggered massive sell-offs of Italian assets.
The rating agencies deny vigorously any wrongdoing.
On Friday, Italian inflation-linked bonds sold off sharply as the downgrade would cause them to drop out of an important bond index. Linkers represent only a small portion of Italy's debt.
The yield difference between 10-year Italian government bonds and German Bunds remained at around 475 basis points, a high level that is frustrating the government in Rome and that Federico Ghizzoni, who heads of Italy's biggest bank by assets UniCredit, has called 'unsustainable'.
Monti this week did not rule out tapping euro zone bailout funds through a new bond-buying system to help ease Italy's borrowing costs. But Moody's said an Italian request for external assistance could trigger a further downgrade.
The country's economy is projected to contract by as much as 2 percent, dimming the prospect of implementing reforms.
Analysts estimate foreigners hold about one third of Italy's public debt, down from 40 percent a year ago. Foreign deposits at Italian banks have fallen 20 percent year on year.
"This is just Moody's opinion. I think our country, and our manufacturing system, is much stronger than the Moody's evaluation suggests," domestic business association head Giorgio Squinzi said.
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