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UPDATE 1-Portuguese bond demand hits fever pitch after 2-notch Fitch upgrade

(Updates with more details)

* Fitch lifts Portugal rating by unprecedented 2 notches

* Portugal has BBB investment grade rating for Fitch

* Could soon return to major bond indices

* Portuguese yields slide, trade below Italy

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

LONDON, Dec 18 (Reuters) - Portugal's bond yields hit their lowest since early 2015 on Monday, after an unprecedented two-notch upgrade from Fitch that means it holds an investment grade from two of the three major rating agencies and could soon return to major bond indices.

Fitch, which had rated the country BB+, shifted position late Friday to BBB, two notches into investment grade territory and with a stable outlook, citing a diminishing debt to GDP ratio.

While investors had anticipated an upgrade from Fitch back into investment grade territory after a similar move from Standard & Poor's in September, the two-notch upgrade took many by surprise and unleashed a fresh rally in a bond market that has already had a stellar performance this year.

Portugal's 10-year bond yield tumbled almost 8 basis points to 1.73 percent, its lowest level since early 2015, and was set for its biggest one-day fall since late October.

Having traded briefly below Italian bond yields on Friday ahead of the ratings decision, Portuguese yields moved decisively below their Italian peers on Monday.

Italy's 10-year bond yield was flat on the day at 1.81 percent and 6 bps above Portuguese peers. The last time Portuguese yields traded below their Italian peers for a sustained period was in early 2010.

"The outperformance we are seeing is because we had a two notch upgrade, which means yields trading below Italy is justified by the better backdrop for Portugal," said DZ bank rates strategist Daniel Lenz.

"There is very much a shift in the architecture in the European government bond market."

Portuguese bond yields were the clear outperformer of euro zone bond markets, with yields elsewhere flat to 1 bps higher on the day.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s

(Reporting by Dhara Ranasinghe; Editing by Toby Chopra)