Portugal yields dip as investors see limited BES fallout for bonds
* Portuguese bonds claw back some of Monday's losses
* Naked short selling ban on Banco Espirito shares stems sell-off
* Other lower-rated euro zone yields dip on ECB outlook (Recasts with moves in Portuguese yields, adds euro zone data, fresh comments)
By Emelia Sithole-Matarise
LONDON, July 1 (Reuters) - Portuguese bond yields fell on Tuesday as investors saw limited fallout for the sovereign debt from a probe into three holding companies of the country's biggest bank.
Uncertainty over Banco Espirito Santo since news of the investigation by Luxembourg's justice authorities drove its shares down around 16 percent on Monday, had prompted some investors to take profit on a sharp rally this year in Portuguese bonds.
The bonds rebounded on Tuesday after market regulators in Lisbon and London banned naked short-selling of the bank's shares appeared to stem the stock sell-off.
BES shares earlier fell more than 13 percent to their lowest since July last year, before rallying to be up 5 percent by 1202 GMT.
Bond traders and analysts said the recent rise in Portuguese yields was also attracting new buyers who were confident that the country was still on the right path with its fiscal reforms and would weather this round of negative news.
"Portugal has been one of those countries that's shown over time that it's doing the right things in terms of austerity," said Credit Agricole strategist Orlando Green. "Growth has been encouraging, they are able to fund at decent levels. Taking all this into account, it's not an issue than cannot be overcome."
Portuguese 10-year yields were last 8.6 basis points lower at 3.59 percent, having risen as much as 10 bps on Monday. They were, however, still about 40 bps up from 2005 lows around 3.25 percent hit three weeks ago.
Junk-rated Portugal successfully completed its bailout deal in May and returned to the bond market this year with regular debt auctions which have been well bid. The rejection of some budget cuts by the constitutional court earlier this month caused only brief selling pressure in the market.
The bonds were among the best performers in peripheral euro zone bond markets in the first half after the European Central Bank took unprecedented monetary policy measures, fuelling a two-year rally.
Final data showing euro zone manufacturing activity eased in June to its lowest since November confirmed the bloc's feeble economic growth.
Weak inflation numbers on Monday only served to reinforce bets the ECB could easy policy further, though the fact it did not deteriorate from May's 0.5 percent reading gave the bank room to hold off on further steps at this week's meeting.
"The ECB will certainly take this data into account and EMU inflation remains at a very low level and this rather supports the dovish tone of the ECB in general but not changing their view for now," said Christian Lenk, a strategist at DZ Bank.
"This should keep yields subdued but we don't expect much of a move before Thursday's ECB meeting and also the (U.S.) non-farm payrolls."
Spanish 10-year yields were 2 bps lower at 2.66 percent with Italian equivalents down 1 basis point at 2.74 percent. (Editing by Nigel Stephenson)