* Spanish debt rallies on potential Fitch upgrade
Spain/Germany yield spread narrows to 93.3 bps
* High-grade euro zone yields flat to a touch higher
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates prices)
By Abhinav Ramnarayan
LONDON, Jan 19 (Reuters) - The premium investors demand to hold Spanish government bonds over benchmark German debt dropped to its lowest in six months on Friday on expectations of a ratings upgrade that would give Spain its first "A" rating since the euro zone debt crisis.
Fitch Ratings is due to review Spain's credit rating late on Friday, and analysts expect a strengthening economy and declining political risk will lead it to upgrade the sovereign to A- from BBB+.
That would restore it to single-A status for the first time since 2012, at the height of the euro zone debt crisis, when Spain was downgraded by all three main ratings agencies.
On Friday, when most high-grade euro zone bond yields were flat to a touch higher, Spain's 10-year borrowing costs dropped 6 basis points to 1.43 percent, a one-month low.
That narrowed the gap between Spanish and German 10-year yields to 93.9 basis points. It briefly hit 92.5 bps, its tightest level since March 2015 .
"We now consider that there exists a slightly higher probability that Fitch will upgrade Spain by one notch than that it will reaffirm the BBB+ rating," said BBVA strategist Jaime Costero Denche. "It is only a question of time before all the main rating agencies upgrade their ratings on Spain."
Moody's rates Spain Baa2 and S&P Global BBB+.
Spanish gross domestic product grew 3.1 percent in 2017, making it one of the best-performing economies in Europe, but concern over an independence bid by the region of Catalonia kept it from being upgraded. Those uncertainties continue.
U.S. 10-year Treasury yields climbed to 2.64 percent early on Friday, their highest in more than three years, as legislation to keep the federal government running hit obstacles in the Senate late on Thursday.
As a result high grade euro zone bond yields opened 1-2 bps higher, but they were down by 0-2 bps in late trading.
Germany's 10-year government bond yield, the benchmark for the euro zone, was marginally lower at 0.503 percent. .
An improving global economy and expectations of central bank tightening have been pushing up the yields of most major developed country debt. The latest trigger has been faster-than-expected Chinese growth in the fourth quarter of 2017.
"The market seems keen to test the 2.64 percent level in 10-year US Treasury yields, which has held repeatedly in recent years and is seen by some commentators as the dividing line to a bear market in bonds," Commerzbank analysts said in a note.
(Reporting by Abhinav Ramnarayan, additional reporting by Fanny Potkin; Editing by Catherine Evans)