Lower-rated euro zone debt rallies on improving economic data
* Spanish, Italian premiums over Bunds fall below 200 bps
* Spanish jobless data reinforces improved economic outlook
* Portuguese yields drop as president backs budget
* "Light at the end of the tunnel" - strategist
By Marius Zaharia and Ana Nicolaci da Costa
LONDON, Jan 3 (Reuters) - Lower-rated euro zone bonds rallied on Friday as a drop in Spanish unemployment and a move by Portugal's president to side with the government on the 2014 budget added to signs the region is coming out of its crisis.
The number of people unemployed in Spain fell by 2.24 percent in December, the biggest drop ever for that month, and the second biggest fall since the data series began.
In Portugal, the presidency said late on Thursday it has received legal advice that the 2014 budget does not infringe the constitution and it is not planning to send it to the constitutional court as it did last year.
The court is still likely to scrutinise some of the budget's cuts, complicating Lisbon's plans to exit its international bailout this year. But the president's support could weaken the case of the leftist opposition parties, which have long promised to challenge the budget in court.
The premium that Spanish 10-year bonds offer over benchmark German Bunds fell below 200 basis points for the first time since May 2011, while in Portugal, the equivalent yield gap shrank to about 375 bps, the tightest since February 2011.
Spain's 10-year yields fell 8 bps on the day to 3.90 percent, while equivalent Portuguese yields fell 17 bps to 5.70 percent. Italian, Irish and Greek yields also fell, while other euro zone bonds were flat.
"Markets are continuing to bet that the euro zone crisis is over ... and the positive news from the Portuguese certainly helped," said Philip Shaw, chief economist at Investec.
"We've moved outside of a negative debt spiral ... towards a positive cycle. The improving economy is helping public finances and that is bringing back confidence and so on."
The "peripheral" bonds of the euro zone's weaker economies extended a rally made on Thursday after stronger than expected manufacturing surveys in Spain and Italy. Analysts expect riskier bonds to continue to outperform top-rated ones as the global recovery gathers pace.
"(The Spanish unemployment) number ... really highlighted that there is light at the end of the tunnel," Orlando Green, European fixed income strategist at Credit Agricole said.
Top-rated "core" bonds have started the year on a more cautious note.
Even though the European Central Bank is expected to stick to its soft tone on monetary policy, analysts see further room for German yields to rise as major economies bounce back and as the Federal Reserve trims its monthly asset purchases.
"We expect euro zone spread convergence as the economic recovery picks up, the Fed tapers and German bonds underperform," Lyn Graham-Taylor, fixed income strategist at Rabobank, said.
German Bund futures closed 3 ticks lower at 139.09, with 10-year German yields flat at 1.94 percent, hovering near their highest since September.
Volumes remained low after the year-end holidays with turnover below 250,000 lots in the European session, a fraction of the 2013 daily average of about 680,000 lots.
"Markets at the moment are repositioning with regards to better economic conditions and tapering. This is weighing on German Bunds, but with yields close to 2 percent I think there is the potential for some relief," Patrick Jacq, European rate strategist at BNP Paribas said. "The conditions are still there for tighter spreads in the periphery."
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