DUBLIN (Reuters) - Moody's cut Ireland's credit rating yesterday, warning the country still faces a slow climb out of recession after nearly two years of austerity as the cost of rescuing its banking sector mounts.

The rating agency's one-notch drop to Aa2 came a day ahead of a scheduled sale of up to 1.5 billion euros of Irish debt, putting Moody's on par with rival agency Standard and Poor's' AA rating and still one grade above Fitch.

The downgrade, which a minister said provided no surprises but which briefly weakened the euro against the dollar and hit European stocks, prefaced a sale of six- and 10-year bonds worth between 1 billion and 1.5 billion euros at Ireland's regular monthly auction.

Moody's also changed its outlook to stable from negative, and much of the hit to Irish bond markets was short-lived.

The spread of Irish 10-year bonds against their German equivalent widened 10 basis points on Monday from Friday to 301 basis points, their highest since July 2, before narrowing to 295 bps.

"The timing isn't great, given the bond auction tomorrow and certainly this will add to the premium that will need to be paid to raise money," Alan McQuaid, chief economist at Bloxham, said.

Dietmar Hornung, Moody's lead analyst for Ireland, said the downgrade was "primarily driven by the Irish government's gradual but significant loss of financial strength".

Some of the euro zone's toughest spending cuts last year gave Ireland respite from the market assault on other peripheral euro zone countries such as Greece, Spain and Portugal.

But Dublin's fiscal discipline has been all but overshadowed by fresh rounds of bad news from the banks.

The cost of bailing out nationalised Anglo Irish Bank ANGIB.UL last year gave Ireland a budget deficit of 14 percent of gross domestic product, the highest in Europe, and this could rise to 20 percent this year, the state-funded Economic and Social Research Institute (ESRI) said last week.

Germany's Bundesbank said yesterday economic imbalances in peripheral euro-zone countries pose risks to the bloc as a whole and made it clear they should not look to Germany to get them out of the mess.

With Ireland having emerged from the euro zone's longest running recession in the first quarter, Moody's said it expected economic growth of two to three percent per year from 2011, below the four percent forecast built into the government's fiscal programme.

Moody's said banking and real estate — engines of growth in the years preceding the country's crisis — would not contribute meaningfully to Irish growth in the coming years.

"It's really not telling us anything that we don't know already," said Martin Mansergh, Ireland's minister of state for finance. "We all know that banking and real estate are not going to be sources of growth."

The IMF last week said Dublin would not meet a European Union-agreed deadline to reduce its budget deficit to three percent of gross domestic product (GDP) by 2014, also citing threats to Ireland's growth target.