* Fitch lifts Portugal rating by unprecedented 2 notches
* Portugal has BBB investment grade rating for Fitch
* Could soon return to major bond indices
* German yield curve flattest in almost 6 months
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (rewrites throughout, updates prices, adds Germany)
LONDON, Dec 18 (Reuters) - Portugal's bond yields hit their lowest since early 2015 in early trading before inching up, after an unprecedented two-notch upgrade from Fitch boosted investor optimism. 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.
In morning trades on Monday, Portugal's 10-year bond yield tumbled to 1.73 percent, its lowest level since early 2015.
Portuguese yields moved decisively below their Italian peer on Monday for part of the European trading session, a first since early 2010.
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.
However by the end of trading, the yield difference had evaporated. Portugal's 10-year bond yield rose up to 1.804 percent, while Italy's stayed at 1.81 percent.
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 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."
Along with Greece, Portugal is the bloc's best performing government bond investment of 2017.
Returns on both Portuguese and Greek 10-year government bonds were up around 20 percent each this year, according to Thomson Reuters Datastream.
This is well above returns of 2-4 percent from other euro zone economies including southern European peers Italy and Spain, and benchmark bond issuer Germany.
Meanwhile, the yield curve in Germany, the euro zone's biggest economy and its benchmark bond issuer, was its flattest in almost six months, Tradeweb data showed on Monday.
The gap between German 30 and 2-year bond yields shrank to 178 basis points, its tightest since late June.
(Reporting by Dhara Ranasinghe; Editing by Toby Chopra)