* Brighter economic outlook fuels flows into Spain, Italy
* Bund futures rebound after ECB-triggered selloff
* Trade cautious ahead of U.S. jobs data
By Emelia Sithole-Matarise
LONDON, March 7 (Reuters) - Spanish and Italian bond yields fell back to their lowest levels in nearly 8-1/2 years on Friday after a solid debt sale in Madrid this week as an improved economic outlook in the euro zone fuelled investor demand.
The market was also stabilising after a sell-off in top-rated bonds on Thursday on disappointment that the European Central Bank signalled it was in no hurry to loosen monetary policy further despite ultra-low inflation.
Although money markets have all but priced out prospects for further policy easing in coming months, some in the market say the ECB's pledge to maintain an accommodative policy and that it might act if economic conditions deteriorated supported demand for peripheral euro zone debt.
Spanish and Italian 10-year yields fell 4 basis points to 3.39 percent and 3.43 percent respectively, back at October 2005 lows.
"The Spanish auction yesterday was taken down pretty comfortably and peripherals in general have performed very well even with jitters over Ukraine which is a reflection of the improving sentiment towards the euro area current recovery as a whole," said RIA Capital Markets strategist Nick Stamenkovic.
"As long as the economic picture in the euro area, particularly in the periphery, continues to improve and given that overseas investors are increasing exposure to peripheral markets there's another leg lower in peripheral spreads."
Spanish 3- and 5-year borrowing costs hit record lows at a debt auction on Thursday of up to 5 billion euros of bonds, adding to a string of solid debt sales so far this year.
Commerzbank strategists said they saw scope for further outperformance in the secondary market for shorter-dated Spanish and Italian bonds, especially against higher-rated French debt.
"We therefore recommend investors to stick to strategic longs in 5-year Spain and Italy versus France, expecting another 25 basis point spread convergence over the coming weeks," they said in a note.
Elsewhere, German Bund futures rose 18 ticks to 142.36, clawing back some ground after suffering their biggest one-day fall since late December on Thursday after the ECB refrained from new stimulus measures. Cash 10-year Bund yields were 1 basis point up at 1.64 percent.
Activity was, however, subdued before U.S. non-farm payrolls data that will provide insight on the state of the world's biggest economy and could influence the Federal Reserve's policy outlook.