* Spain beats target at debt sale, yields fall
* Demand supported by expectations of further ECB easing
* Spain completes a fifth of 2014 funding target
By Marius Zaharia
LONDON, Feb 6 (Reuters) - Spanish bond yields fell on Thursday after a larger than usual debt auction went smoothly, boosted by expectations that the European Central Bank may ease monetary policy further.
Extending the trend of solid debt sales this year, Madrid issued a more than planned 5.6 billion euros in three- and five-year bonds to complete more than a fifth of its 2014 funding goal already.
The historically low yields or the sizeable amount on offer - Spain usually sells 3-4 billion euros at auctions - were not enough to dent investor appetite.
Expectations that the ECB may ease policy further, possibly even at its meeting later on Thursday, are likely to keep top-rated bond yields anchored at ultra-low levels and encourage investors to seek higher returns in lower-ranked assets.
"Expectations for more ECB action have definitely been an important driving force for tighter intra-euro (yield) spreads," said Jussi Hiljanen, chief fixed income strategist at SEB in Stockholm.
Spanish 10-year yields fell 4 basis points to 3.69 percent, slightly above the eight-year lows of 3.63 percent hit at the start of the week, but still about 50 bps lower than at the end of 2013. Spanish three- and five-year yields were also slightly above similar historical lows.
Spanish bonds, also boosted by an improved growth outlook, outperformed most of their euro zone peers on Thursday.
A surprise fall in euro zone inflation to 0.7 percent in January has increased pressure on the ECB to defend its price growth target of close to but under 2 percent.
A Reuters poll showed the vast majority of money market traders expected the ECB to keep rates on hold. But some in the market expected more easing.
Barclays strategists expect the ECB to cut its main refinancing rate to 0.15 percent from 0.25 percent and the deposit rate to minus 0.10 percent from zero - a move which would effectively penalise banks for depositing cash at the ECB and not lending them to other banks, businesses or consumers.
Some market participants also expect the ECB to stop draining the amount equal to its crisis-era bond purchases every week from money markets as it usually does. This would release almost 180 billion euros in the interbank market, pushing short-term rates lower.
"Investors have started to position for either a dovish ECB or... for some sort of surprise (easing)," said Luca Cazzulani, UniCredit rate strategist in Milan.
EXPECTED TO ACT
The forward overnight euro zone bank-to-bank borrowing rates market, one of the best barometers for the perceived ECB outlook, suggests expectations the ECB is likely to hold fire on Thursday but may ease policy later this year.
The Eonia rate dated for the February meeting stood at 0.16 percent, in line with recent spot fixings, but the March Eonia was below 0.13 percent and May to November rates between 0.08 and 0.10 percent.
"Should the ECB do nothing ... we might see some selling (in euro zone bonds)," said Mathias van der Jeugt, rate strategist at KBC in Brussels.
German 10-year yields, the benchmark for euro zone borrowing costs, rose 2 bps to 1.56 percent, having hit their lowest since July 2013 at 1.507 percent on Wednesday.
"I don't think the market is particularly long (on Bunds) so there's room for some sizeable gains there if they cut. The market is long of periphery but any signs of easing from the ECB should support them as well," one trader said.
"Also there's room for disappointment if he (ECB President Mario Draghi) is not as aggressive as the market thinks he should be but ... (any sell-off) should be short-lived because I think he is just putting off the inevitable."