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By Jamie McGeever
LONDON, March 28 (Reuters) - The euro slid to a three-week low and government bond yields across the euro zone fell on Friday as a surprise fall in Spanish inflation bolstered investors' bets the European Central Bank will ease policy next week to ward off the threat of a sustained bout of deflation.
Spanish and Italian borrowing costs fell to their lowest in eight years, while stock markets drew support from the renewed potential for looser ECB policy and reports Beijing could fast track infrastructure spending to boost the Chinese economy.
The 0.2 percent annual rate decline in Spanish consumer prices this month was larger than expected and the weakest figure since October 2009.
The Spanish numbers put preliminary German inflation data for March later in the day under even greater scrutiny for signs that the threat of deflation is spreading from peripheral euro zone economies like Spain to the bloc's powerful core.
"This is an ECB expectations-driven story," said Ralf Umlauf, an analyst at Helaba Landesbank Hessen-Thueringen. "The market is definitely positioning for next week's meeting. Market players are expecting some action - any kind of action."
The euro hit a three-week low of $1.3704, falling further back from the $1.40 level many analysts think would be too strong for the fragile euro zone economy in the eyes of ECB policymakers.
At 1125 GMT it had recovered some ground to trade little changed on the day at $1.3735.
Spanish and Italian yields were flat on the day around 3.24 percent and 3.3 percent, after having slipped earlier to eight-year troughs of 3.2 percent and 3.27 percent, respectively.
Portugal's 10-year yield dipped below 4 percent for the first time in over four years.
The ECB sets policy on Thursday next week, when it will have the euro zone-wide flash inflation estimate for March due on Monday. Economists expect that to slip to just 0.6 percent, well below the ECB's target of below but close to 2 percent.
Europe's main equity markets were all higher, posting early gains of up to four fifths of percent.
The FTSE Eurofirst 300 index was up 0.4 percent at 1327 points, on for its fourth straight day of gains as investors square positions at the end of the quarter.
After the respective eight and six percent gains of the previous two quarters, equity investors have been much more cautious in the first three months of the year. The FTSE Eurofirst 300 is on track for a gain of around 1 percent.
Europe followed Asia and emerging markets higher on the back of comments from China's Premier Li Keqiang, who was quoted by state media as saying the government would roll out targeted measures step-by-step to aid the economy.
"We're making a little bit of a jolt higher, based on hopes of some form of Chinese fiscal stimulus, but that's not the big game in town. The big question for China is whether it can deflate its credit bubble without creating a burst," said Jeremy Batstone-Carr, analyst at Charles Stanley.
"The bounce we're seeing today is a short-term effect."
MSCI's index of Asia-Pacific shares outside Japan added 0.7 percent and Japan's Nikkei closed at a three-week high of 14,696 points ahead of the end of their financial year on March 31.
Emerging markets showed signs of recovering from a bruising few weeks, with hopes of further Chinese stimulus pushing with the military and geopolitical tensions surrounding Russia and Ukraine further into the background.
"The prospect of an economic rebound (in China) is likely to be priced into markets as policy support is announced. If so ... it seems plausible that H1 2014 will mark the low water point in emerging market equity performance," wrote Barclays in a note to clients.
The MSCI index of emerging shares has climbed for six straight sessions to the highest since January 3. The index for Latin America on Thursday boasted its biggest daily gain since July 2012 as Brazilian markets rallied.
In U.S. bond markets, Treasury yields were capped by the fall in European bond yields. Ten-year U.S. borrowing costs hovered around 2.68 percent, a couple of basis points above Thursday's 11-day low.
Gold looked to snap its broad losing streak this month, rebounding from Thursday's six-week low to trade up 0.4 percent on the day at $1,295.00 an ounce.
In the oil market, U.S. crude futures were almost flat on the day at $101.43 a barrel. (Reporting by Jamie McGeever, Marius Zaharia and Alistair Smout; Editing by Toby Chopra)