MILAN, July 13 (Reuters) - Italian three-year borrowing costs are expected to retreat below 5 percent at a bond auction on Friday as progress on a Spanish bank bailout brings some respite in euro zone market tensions that analysts say could nevertheless easily flare up again.

Italy last sold three-year bonds a month ago, right before pivotal elections in Greece and soon after a sketchy accord to support Spanish banks that had failed to reassure investors. It paid an average 5.3 percent yield then, the highest since December.

On Friday, the Treasury offers up to 5.25 billion euros in bonds, including a new three-year issue carrying a 4.5 percent coupon. It will also sell new tranches of three bonds due in 2019, 2022 and 2023 that are no longer issued on a regular basis.

The new bond traded at around 4.8 percent late on Thursday, pointing to a likely fall in the cost of borrowing.

"Part of the fall in yields we saw lately is a product of progress achieved on Spain and its banks," said Intesa Sanpaolo strategist Chiara Manenti. "I think the first step taken towards joint bank supervision (at an end-June EU summit) also helped."

Volatility on bond markets is still high and sentiment remains extremely fragile. Prime Minister Mario Monti this week did not rule out Italy the possibility of needing in the future to seek support for its bonds from the euro zone's rescue funds.

"The backdrop remains fundamentally challenging," analysts at Citi said in a note.

Domestic demand should help the Treasury clear the sale, thanks also to the relatively small amounts offered both for the new issue and the other three bonds. These were probably specifically requested by primary dealers.

A decision to cancel the mid-August bond sale - in line with a practice adopted in recent years - should also be supportive.

On Thursday, Italy saw its one-year debt costs drop by more than one percentage point from a month earlier at a bill sale.

Euro zone finance ministers this week made 30 billion euros available by the end of July for troubled Spanish banks. Madrid unveiled further austerity measures on Wednesday after being granted more time to meet its fiscal targets.

Saddled with a 1.95 trillion euro debt pile and chronic growth problems, Italy has been hit by the investor concerns over Spain, with the two countries often bracketed together as the most vulnerable to a worsening in the crisis.

"Italian paper is benefiting from the slightly more positive assessment of the Spanish rescue package over the past few days. Italy's perceived creditworthiness is externally driven," said Nicholas Spiro at Spiro Sovereign Strategy.

"Right now, this is working in Italy's favour, but we find it extremely worrying that there is still insufficient differentiation between Spain and Italy in the markets."

Italy has greater funding needs compared to Spain but it can rely on a bigger and more diversified domestic investor base.

With euro break-up worries keeping foreign investors away from Italian bonds, domestic support is key for the Treasury, which has roughly another 180 billion euros in debt to raise before the end of 2012. (Editing by Hugh Lawson)