* Portugal/Germany yield gap tightest in 2-1/2 years
* Portugal/Italy spread narrowest since 2010
* Euro zone GDP data lift sentiment in periphery
* Bond yields broadly lower
* Euro zone periphery government bond yields tmsnrt.rs/2ii2Bqr (Updates prices)
By Dhara Ranasinghe
LONDON, Nov 14 (Reuters) - The premium investors demand for holding Portuguese bonds over their top-rated German peers fell to its lowest level in more than two years on Tuesday, as upbeat economic data encouraged investors to increase their exposure to peripheral bond markets.
A fall in Portuguese bond yields, down some 85 basis points in the past two months, also pushed borrowing costs in the southern European state a step closer to those in Italy with the gap between the two at its narrowest since 2010.
Euro zone bond yields were broadly lower, reversing early rises as markets digested comments from major central bankers speaking at a conference in Frankfurt.
But the biggest moves came from Portugal for a second straight day, with analysts saying expectations for another ratings upgrade were boosting demand for local debt.
Data on Tuesday showed the euro zone economy grew 2.5 percent year-on-year in the third quarter, compared with 2.3 percent in the second quarter. Germany’s economy shifted into an even higher gear in the quarter, propelled by buoyant exports and rising company investments in equipment .
“We have this backdrop of better-than-expected growth, and that can mask a lot of ills,” said Rabobank rates strategist Lyn Graham-Taylor. “It looks like investors are using that backdrop to put on carry trades, which is leading to tighter spreads in the periphery.”
Portugal’s 10-year bond yield fell more than 5 basis points to 1.94 percent, narrowing the gap over benchmark German Bund yields to 153 bps -- its tightest in 2 1/2 years. It had pulled back slightly by late afternoon trade but remained 2.5 bps lower on the day.
The Portuguese/Italian bond yield spread tightened to around 13 bps, its narrowest level since 2010.
Portugal has been one of the bloc’s best performing bond markets this year, with a tightening in spreads gathering pace after ratings agency S&P in September restored Portugal to investment grade.
“There is some expectation of another ratings upgrade for Portugal,” said Mizuho rates strategist Antoine Bouvet. “Clients also like Portuguese bonds as a way to get exposure to the periphery.”
Other euro zone bond yields were down 1 to 3 bps on the day. Germany’s Bund yield initially rose after the German economic growth data but were last trading around 2 bps lower at 0.40 percent.
Brighter data helped pushed a market gauge of euro zone inflation expectations to its highest since March, just above 1.70 percent.
Speaking at an ECB-hosted conference in Frankfurt, ECB chief Mario Draghi said the central bank’s “forward guidance” on future policy moves has been successful in steering market expectations.
U.S. Federal Reserve Chair Janet Yellen, Bank of England chief Mark Carney and Bank of Japan head Haruhiko Kuroda were also at the event.
Elsewhere, Germany sold 4 billion euros of a new two-year “Schatz” bond.