* Downbeat China, euro zone PMIs bolster ECB easing bets
* Euro zone debt yields fall across credit spectrum
* Spain, Italy lead falls
* BNP Paribas expects ECB QE in second half of 2014
By Emelia Sithole-Matarise
LONDON, Feb 21 Spanish and Italian bond yields fell back towards eight-year lows on Friday in a broad based rally in euro zone debt as uncertainty over the bloc's growth outlook bolstered expectations of further ECB policy easing.
Surveys on Thursday showed business activity within the currency bloc did not expand as much as expected in February, in a sign the economic recovery remained fragile, particularly outside the region's biggest economy, Germany.
Data from China also painted a grim picture of the country's manufacturing sector, raising questions about the outlook for global growth.
With euro zone inflation running well below the European Central Bank's target of just under 2 percent, this is keeping alive bets the central bank will loosen monetary policy further later this year.
"The China and euro zone PMI data wasn't particularly great and that leaves the door open for ECB action," said Alan McQuaid, chief economist at Merrion Stockbrokers.
Spanish and Italian yields dropped 5 basis points to 3.56 percent <ES10YT=TWEB and 3.61 percent respectively, back near eight-year lows hit on Wednesday.
A smooth debt auction on Thursday which saw Spain meet a quarter of its 2014 funding target is also clearing the way for Spanish bonds to outperform Italian debt.
An improved outlook on Italy and Spain's credit ratings was also spurring flows into their bonds. Moody's is expected to maintain or at least upgrade its outlook on Spain's credit worthiness later on Friday after it upgraded Italy's outlook to stable from negative last week.
Bond investors have also warmed to incoming Prime Minister Matteo Renzi's pledges of ambitious reforms to revive the euro zone's third largest economy.
Renzi, who engineered the resignation of centre-left party rival Enrico Letta from the premiership last week, is expected to confirm his new cabinet later on Friday, a source in Renzi's Democratic Party said. This would allow his government to be sworn in by the weekend before a confidence vote expected in parliament on Monday.
QE FROM ECB?
Ultra-low euro zone inflation is prompting speculation that the ECB might eventually embark on a government bond buying scheme akin to the Federal Reserve's quantitative easing.
Last week ECB policymaker Ewald Nowotny said he did not believe such a programme would be easy for the ECB due to rules forbidding it from state financing.
Bond and money markets are not pricing in such a move from the ECB but BNP Paribas anticipated action in the second half of the year which they said would aggressively drive down Italian and Spanish yields.
"Actual inflation is very low and is probably set to persist at low levels for some time. The risk is to see inflation expectations declining substantially so the ECB has to keep inflation expectations alive and QE is one of the more effective ways to do this," said BNP Paribas' Patrick Jacq.
He said Spanish and Italian 10-year yields could fall to 2.90 percent by the end of the year, some 50-70 bps below current levels.
Societe Generale economists, however, saw only a 15 percent probability of QE from the ECB saying it was more likely to provide further cheap long-term loans to the banking system, deliver a small rate cut or stop soaking up money it used to buy crisis-era euro zone bonds to boost excess liquidity.
"From a strategic point of view, we see risks heavily skewed towards the ECB using such tools to buy time and send a dovish signal as they continue to gauge the need for much bigger action," they said in a note.
Higher-rated euro zone bonds also pushed higher. German 10-year yields were down 4 bps at 1.66 percent. Belgian, Dutch and Austrian yields also fell. Austrian bonds were supported by Fitch's affirmation of the country's triple-A rating with a stable outlook. Fitch said the government could handle the cost of restructuring nationalised bank Hypo Alpe Adria.
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