Madrid sold 2.51 billion euros ($3.27 billion) of debt, right in line with expectations, on demand that soared to more than 13.5 billion euros.

"It was a good auction ...and yields fell sharply," Estefania Ponte, an economist de Cortal Consors, said.

"But the market is starting to get used to good (Spanish) auction results and it didn't react."

Borrowing costs fell sharply from the last time the same maturities were sold in mid-December - a day before the European Central Bank's pushed almost half a trillion euros in three-year loans into the bloc's banks.

At just 1.285 percent and 1.847 percent, respectively, the yields on the three-month paper was the lowest since last February and on the 6-month yield the lowest since June.

Spain has moved away from the sharp end of the euro zone crisis in recent weeks, its debt-servicing program supported by the flood of cheap ECB money along with the bank's regular purchases of Spanish bonds on the market.

Markets have also responded to efforts by the government of Mariano Rajoy, which took office last month, to get to grips with an ailing economy and push ahead with a tough deficit-reduction program.

Spain's three- and six-month auction yields had spiked to just over five percent in November, but by last Thursday the treasury was paying little more than that to sell 10-year debt.

The last time it sold three- and six-month paper it paid 1.735 percent and 2.435 percent, respectively.

Despite the sharp downward move in borrowing costs, the government faces tough times ahead, hamstrung by an economy that is almost certain to shrink in 2012, chronically high unemployment and a bloated banking sector weighed down by soured property loans.

The government says it remains committed to slashing its budget deficit to 4.4 percent of economic output this year, from an estimated 8.1 percent at the end of 2011.

But many in the market are convinced Rajoy will eventually have to ease back on the austerity to avoid triggering an even deeper recession than that forecast by the country's central bank.

The Bank of Spain forecast on Monday the economy will shrink by 1.5 percent this year and grow just 0.2 percent in 2013.

It also said it expected the government to stick to its budget targets - but at the cost of more austerity that will keep unemployment hovering at over 23 percent for the next two years.

($1 = 0.7665 euros)

(Editing by Fiona Ortiz/Patrick Graham)

• A Permanent Economic Emergency