* Spanish, Italian premiums over Bunds fall below 200 bps
* Spanish jobless data reinforces improved economic outlook
* "Light at the end of the tunnel" - strategist
LONDON, Jan 3 (Reuters) - Spanish government bond yields hit their lowest level since September 2010 on Friday after a drop in the country's jobless rate underpinned sentiment and fuelled a bond rally.
The number of registered jobless in Spain fell by 2.24 percent in December. It was the biggest drop ever for that month, and the second biggest fall since the data series began.
Against this backdrop, Spanish government bonds outperformed most of their euro zone peers, pushing their premium over German Bunds below 200 basis points for the first time since May 2011.
"Today's number ... really highlighted that there is light at the end of the tunnel," Orlando Green, European fixed income strategist at Credit Agricole said.
Ten-year Spanish bond yields fell as low as 3.91 percent, pushing the Spanish/German yield spread down to 197 basis points. Yields were last 6 bps lower at 3.93 percent.
"There has been heavy buying," one trader said. "Unemployment collapsed, so I think that's the trigger."
Equivalent Italian yields fell as low as 3.935 percent, pushing the yield spread over Bunds to just below 200 bps for the first time since July 2011. Italian yields were last down 1.4 bps at 3.96 percent.
Other lower-rated debt followed suit, with 10-year Portuguese yields falling 12 bps to 5.76 percent.
Spanish and Italian bonds extended a rally made on Thursday after stronger than expected manufacturing activity data from those countries. Analysts expect riskier bonds to continue to outperform safe-haven ones as the global recovery gathers pace.
Top-rated or so-called "core" bonds have started the year on a more cautious tone.
Even though the European Central Bank is expected to stick to a dovish tone, analysts see further room for German yields to rise as major economies bounce back and as the Federal Reserve trims its monthly asset purchases.
"We expect euro zone spread convergence as the economic recovery picks up, the Fed tapers and German bonds underperform," Lyn Graham-Taylor, fixed income strategist at Rabobank, said.
German Bund futures were down 3 ticks at 139.09, with 10-year German yields flat at 1.95 percent, hovering near their highest since September.
Volumes remained low after the Christmas and new year holidays with turnover only at around 115,000 lots by 1139 GMT, a fraction of the 2013 daily average of about 680,000 lots.
"Markets at the moment are repositioning with regards to better economic conditions and tapering. This is weighing on German Bunds, but with yields close to 2 percent I think there is the potential for some relief," Patrick Jacq, Europe rate strategist at BNP Paribas said. "The conditions are still there for tighter spreads in the periphery."