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Portugal set to halve borrowing costs in 2017 as "junk" label fades

* Portugal's 10-year yields near 2-1/2 year low of 1.78 pct

* Friday's Fitch review could give Portugal second IG rating

* Most Southern European debt yields edge lower on day

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr

LONDON, Dec 12 (Reuters) - Portugal has halved its borrowing costs since the start of the year with its 10-year bond yield close to its lowest level since April 2015 ahead of a potential restoration of its investment grade status by Fitch.

Portugal outperformed the rest of the market on Tuesday and saw its 10-year bond yields -- which move inversely to price -- drop to as low 1.78 percent, a shade away from a 2-1/2 year low hit on Monday.

Hitherto seen as one of the weakest links in the euro zone, Portugal's strong economic performance and narrowing deficit has seen investors favour its debt increasingly this year.

The European Central Bank's decision to extend its asset purchase programme has also helped push down the yields of all the Southern European government debt, seen as the biggest beneficiaries of ultra-loose monetary policy.

The fact that Portugal has far less outstanding bonds than neighbouring Spain and Italy has also compressed yields as investors struggle to find bonds with the ECB buying up a large chunk of the market through its asset purchase scheme.

But the trend accelerated after S&P Global restored Portugal to investment grade status in September and many expect a similar move from Fitch at a scheduled review on Friday.

"We are expecting a one-notch upgrade by Fitch to BBB- on 15 December to be followed by more positive credit actions during 2018," said BBVA strategist Jaime Costero Denche.

Even though it would not be a surprise, Portugal's bonds should still benefit as two investment grade ratings grants inclusion into many of the world's biggest bond indices, he said.

The yield on Portugal's 10-year government bond dropped to 1.785 percent, down 2 basis points on the day and just a shade off the 2-1/2 year low of 1.78 percent hit on Monday.

At the start of the year, the country's 10-year borrowing costs were 3.73 percent and the spread over Germany was 374 bps and over Italy -- the benchmark for Southern Europe -- was 199 bps.

On Tuesday, the Portugal-German bond yield spread was as low as 145 bps and the spread over Italy was just 16 bps.

"We believe Portuguese government bonds could find the sweet spot and test the 140bp spread area versus the Bund, eventually closing the year with yields below (Italian) BTPs in the 10-year sector," said BBVA's Costero.

The ECB's decision in October to extend its asset purchase programme until at least September 2018 has pushed most euro zone government bond yields lower since.

On Tuesday, high grade euro zone edged off recent lows, with benchmark German 10-year yields rising a basis point to 0.30 percent.

Southern European debt outperformed, with yields edging lower to test month-long lows.

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(Reporting by Abhinav Ramnarayan; Editing by Angus MacSwan)