UPDATE 1-Portugal auction points to longer-term market return
* 18-month yield down to 1.963 pct vs 2.990
* 3-month yield drops below 1 pct for first time since 2010
LISBON, Jan 16 (Reuters) - Portugal sold all 2.5 billion euros of Treasury bills on offer on Wednesday and yields fell sharply, lifting chances the bailed-out country will stage a successful return to the longer-term bond market this year.
The IGCP debt agency said the average yield on 18-month T-bills fell to 1.963 percent from 2.990 percent in the previous auction in late November. It sold 1 billion euros of the 18-month issue.
One-year T-bills yielded 1.609 percent, down from 2.101 percent at the previous auction in October and the average yield on the three-month paper dropped to just 0.667 percent from 1.936 percent in November.
The debt agency sold 300 million euros of 3-month bills and 1.2 billion euros of 12-month bills. Demand outstripped the amount placed 2.7 times on 18-month bills, 2.3 times on 12-month bills and 3.8 times on the shortest maturity.
"Portugal's return to the (longer-term) market looks promising at the moment, the yields are where they might start thinking about it," said Elisabeth Afseth, Fixed income analyst at Investec capital markets in London.
She said the country would initially rely more on bond swaps to reduce its funding needs for 2014 and 2015, but bond issues would eventually come.
Portugal's benchmark 10-year bond yields -- at 6.45 percent -- are around their lowest levels since late 2010, before the international bailout in May 2011 that withdrew the country from the primary bond market.
Filipe Silva, head of debt at Banco Carregosa, said the auction was "a good start of the year for Portugal ... auguring well for the Treasury's return to the primary market" after a generalised improvement of market sentiment about the euro zone debt crisis and Portugal's austerity efforts.
"With this positive sentiment, the return to the bond market is now a mere financial management matter for IGCP. It could happen before September, and Portugal has all the winds blowing in its sails," he said.
Still, Portugal's economy is mired in its deepest recession since the 1970s and economists are increasingly forecasting that the slump this year will be much deeper than the government's view of just a 1 percent drop in gross domestic product. The Bank of Portugal on Tuesday forecast a slump of 1.9 percent this year.
Portugal started issuing longer, 18-month T-bills last year and then swapped shorter-dated for longer bonds on Oct. 3 as part of its plan to stage a gradual return to debt markets. Its current 78-billion euro bailout programme covers the country's financing needs up until September 2013.
(Editing by Axel Bugge/Jeremy Gaunt)