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

* 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 (Adds charts, writes through)

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.

The upgrade means Portugal now looks set to return to major government bond indexes after an absence of more than five years.

Most major indexes, such as the Markit iBoxx euro benchmark index and the Bloomberg/Barclays euro aggregate index, use the average ratings of Moody's, S&P and Fitch.

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 in five weeks.

It trimmed those falls but remained about 4 bps lower in mid-morning trade in Europe.

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 down 2.4 bps on the day at 1.80 percent but 2 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."

While Portuguese bonds have been bolstered by a stronger-than-expected economic performance, improved fiscal position and political stability, Italian bonds have been undermined in recent weeks as focus turns to elections early next year.

The leader of Italy's main opposition party said at the weekend he was keeping the option of a referendum on the euro open in the event his party won elections and failed to convince Brussels of the need to change some of the euro zone's economic rules.

A snap election meanwhile takes places in Catalonia on Thursday with the Spanish government hoping the vote will put an end to the wealthy region's independence bid.

Against this backdrop, Portuguese bonds outperformed peripheral and higher-rated euro zone peers.

The gap between Portuguese and benchmark German 10-year bond yields narrowed to around 148 bps -- its tightest since early 2015.

Portugal's bond spread over Spain tightened to around 30 bps -- the narrowest in almost eight years.

"The direction of travel is still for Portuguese bonds to perform well," said Nick Gartside, international chief investment officer for fixed income at JP Morgan Asset Management, one the world's largest investors. "We've liked the periphery all year and still do."

(Reporting by Dhara Ranasinghe; Editing by Toby Chopra)