* Spanish, German CPI push peripheral bond yields to new lows
* Expectations growing ECB will ease further
* Italian 10-year auction yield lowest since October 2005 (Updates prices, adds German inflation, comments)
By Marius Zaharia
LONDON, March 28 Spanish, Italian, Portuguese and Irish bond yields fell to new lows on Friday as subdued Spanish and German inflation data bolstered expectations the European Central Bank will ease monetary policy further.
Italy's cost of borrowing over 10 years fell to its lowest since October 2005 at a Friday auction. It raised the top end of its larger-than-usual 7.5-10 billion euros target.
With some market participants betting that eventually the ECB may even begin to print money via asset purchases, yields on top-rated debt are pinned at ultra-low levels. That is prompting investors to look down the ratings scale to maximise returns.
The soft inflation data have increased speculation that the ECB may at least give clearer hints on how much it is prepared to loosen monetary strings at its monthly meeting next Thursday.
Data showed on Friday that Spanish consumer prices were down 0.2 percent year-on-year in March, compared with a previous reading of 0.0 percent and a Reuters poll forecast of a 0.1 percent rise. German inflation was also below forecast at 0.9 percent.
That led to expectations inflation for the whole euro zone, due on Monday, will fall even below the 0.6 percent Reuters consensus. The ECB's target is just below 2.0 percent.
"Inflation trending lower (is) maintaining hopes for some action from the ECB next week," said Chris Scicluna, head of economic research at Daiwa Capital Markets.
He added that he did not expect the ECB to act, because inflation may have reached a trough in March and business confidence indicators pointed to the euro zone recovery gaining strength.
Italian 10-year bond yields fell to their lowest in 8 1/2 years at 3.261 percent, before rebounding to 3.32 percent as dealers sold some of the bonds they bought at the auction back to the market.
Spanish 10-year yields also reached their lowest in eight years at 3.2 percent. Irish yields dipped to a record low of 2.974 percent, according to Reuters data.
"Investors are transfixed by inflation and monetary developments in the euro zone," said Luca Jellinek, European head of fixed income at Credit Agricole. "An increasing portion of the market is betting that the increasing stream of hints and comments on ... (asset purchases) by the ECB will result in some bond-friendly action."
Portuguese 10-year yields fell faster than most of their euro zone peers to touch levels below 4 percent for the first time in four years, as investors grew more confident it will make a clean exit from its bailout programme in May.
Rabobank strategists recommended that investors buy Portuguese debt against German Bunds, targeting a 200-basis-point gap between the 10-year yields of the two issuers, versus roughly 250 bps on Friday.
At the height of the crisis, the premium Portuguese bonds offered over Bunds, the benchmark for euro zone borrowing costs, was more than 1,500 bps.
"Approaching the exit of the bailout is sufficient to drive Portuguese yields further down," DZ Bank strategist Christian Lenk said. (Editing by Larry King)