Greece ratings move could smooth crucial bond market return
* Some banks predict two notch upgrade from Moody's
* Investors say bond issue will be watershed moment
* Italian yields hit record low after QE talk
* Rest of periphery rallies (Updates with Italian yields at record low, adds fresh comments)
By John Geddie and Emelia Sithole-Matarise
LONDON, April 4 (Reuters) - The rally in Greek bonds could get another boost if Moody's upgrades Greece's credit rating, helping smooth the country's planned return to market just two years after it defaulted.
Moody's is scheduled to release its review of Greece's rating after the market close on Friday, with banks such as RBS predicting as much as a two notch upgrade.
Though still deep in junk territory and below the ratings of the other two main credit agencies, an upgrade by Moody's would aid Athens' plans to issue a bond that investors believe will be a definitive step in the country's turnaround.
Greece's imminent return to markets also comes as the European Central Bank hinted on Thursday that it could make asset purchases to fend off potential deflation, stoking investor appetite for euro zone bonds.
"This is the beginning of the end of the sovereign debt crisis for Greece," said Jason Manolopoulos, managing partner at Dromeus Capital, an asset manager which holds Greek bonds.
Greece hired a group of banks to manage the sale of a 2 billion euro five-year bond on Thursday, Thomson Reuters market service IFR reported.
The bond is slated to be issued sometime this month, with some market participants expecting it as soon as next week.
The country, which has been locked out of capital markets since it accepted the first tranche of a 240 billion euro bailout in 2010, is rated Caa3 by Moody's, nine notches below investment grade. Standard and Poor's and Fitch rank Greece six notches below investment grade at B-.
"The expected rating upgrade, and the subsequent return of Greece, will give Greek yields another boost," said Christian Lenk, fixed income strategist at DZ Bank, predicting 10-year yields to fall below 6 percent.
Greek 10-year yields were slightly lower on the day at 6.15 percent.
EYEING ECB QE
Other peripheral euro zone countries are also seeing tumbling borrowing costs, with markets heartened by Thursday's comments from the ECB that its policymakers are now unanimously agreed that outright money-printing - or quantitative easing - is an option.
A German newspaper report on Friday saying the central bank has modelled the economic effects of buying 1 trillion euros ($1.37 trillion) of securities as part of a QE programme gave such a scenario further impetus.
Italian 10-year yields hit a record low of 3.186 percent while Spanish equivalents fell 7 bps on the day to a new 8-1/2-year low of 3.19 percent.
"The market is probably running ahead of any announcement. The more there's spread compression the more there will be some consolidation and correction near term because the move is quite massive and we don't expect the ECB to announce something before a couple of months," said BNP Paribas strategist Patrick Jacq.
"But clearly the market is positioning for such a decision."
Yields on junk-rated Portuguese bonds dropped 11 bps to 3.87 percent, the lowest since December 2009. Portugal is set to resume bond auctions this quarter after suspending them after its bailout in 2011, and will benefit in particular from any QE programme, say strategists.
"Because Portugal has a relatively small issuance programme, even if the ECB buys a share of bonds in relation to the index, it will have a disproportionate benefit for the country," said Alessandro Tentori, global head of rates strategy at Citi.
Portugal's 10-year yields were 8 basis points lower on the day a 3.90 percent, a new four-year low.
Irish equivalents were 5 bps lower at 2.97 percent.
At the other end of the credit spectrum, German 10-year yields, the benchmark for euro zone borrowing costs, fell 5 bps to 1.56 percent after a slightly below-forecast U.S. jobs report and as investors mulled hints about possible ECB QE. (Editing by Susan Fenton)