EURO GOVT-Strong auction lifts Bunds, Portuguese yields drop
* Demand strong at a five-year German debt sale
* Surprise rise in German industrial output caps Bund gains
* Accommodative ECB policy to support peripheral debt
By Marius Zaharia and Ana Nicolaci da Costa
LONDON, May 8 (Reuters) - A strong auction of German five-year bonds and reassurance from the European Central Bank that it is not a "toothless tiger" lifted Bund futures off three-week lows on Wednesday.
Portuguese bonds also gained after a strong syndicated 10-year debt sale on Tuesday put it on course to leave its bailout programme and reinforced appetite for high-yielding euro zone bonds.
Expectations that the ECB may ease policy further led to gains for both benchmark German Bunds, whose yields are anchored by official rates, and the debt of vulnerable peripheral economies which investors buy to maximise returns in a low-rate environment.
With policymakers reiterating the ECB has room to manoeuvre should the economy worsen further, and Executive Board member Yves Mersch saying the bank was not a "toothless tiger", analysts expect euro zone bonds to continue to rally together.
"(Germany) had a decent auction this morning ... and Portugal's sale yesterday was a success," said Alan McQuaid, chief economist at Merrion Stockbrokers in Dublin.
"The main theme here is the search for yield and Bunds are probably going to be supported by the ECB's stance as well, even if they don't offer much (return) value at the moment."
Bund futures were last 41 ticks higher on the day at 145.84, off a three-week low of 145.37 hit on Tuesday.
Most gains were made after an auction of new five-year bonds attracted bids worth 2.1 times the amount on offer, above the 1.875 average for this year. The sale got stronger demand despite the lower yields of 0.38 percent versus a 2013 average of 0.498 percent.
Data showing German industrial output unexpectedly rose in March took the shine off Bunds in the early part of the session, but the impact was short-lived.
"One data point doesn't make a trend," Michael Leister, senior interest rate strategist at Commerzbank.
"It's some relief after the poor data of the past month but the market is going to see whether it's just a one-off or indeed signals a turnaround in the underlying data flow."
Portuguese 10-year yields were 7 ticks lower on the day at 5.47 percent, the lowest since September 2010. Early in 2012, when many investors thought Portugal would follow Greece and restructure its debt, yields topped 17 percent.
"A market that no one wanted to buy a year or so ago is now bid very aggressively with much lower yields. That's a pretty positive sign," a trader said. "There is still more appetite to buy rather than liquidate (peripheral bonds)."
Spanish and Italian 10-year yields edged down to 4.10 and 3.84 percent, respectively, not far from their lowest levels since 2010 hit on Friday.
Merrion's McQuaid said the spread between Spanish and Portuguese 10-year yields could soon halve to levels of around 70 bps seen earlier this year as demand for high-yielding assets tightens spreads across the euro zone.
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