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UPDATE 2-Euro zone bond yields slide as weak PMI rattles markets

Dhara Ranasinghe

* German private sector shrinks for first time in over 6 years

* Euro zone bond yields slide

* Spain outperforms after S&P ratings upgrade

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates prices, move in market inflation expectations, adds chart)

LONDON, Sept 23 (Reuters) - Bond yields across the euro area tumbled on Monday after weaker-than-expected business activity data from the bloc's biggest economies deepened investors' recession fears.

German private sector activity shrank for the first time in 6-1/2 years in September as a manufacturing recession worsened and growth in the service sector lost momentum.

Markit's flash composite Purchasing Managers' Index (PMI), which tracks the manufacturing and services sectors that together account for more than two-thirds of Germany's economy, fell to 49.1 from 51.7 in the previous month.

French business activity also slowed unexpectedly and Markit's euro zone composite flash PMI sank to 50.4 in September from 51.9 in August.

The data sparked a rally in government bond markets, where yields slid. The euro and regional stocks tumbled.

"The bit that will worry markets is that services that have been largely immune now show signs of substantial contagion effect from the slowdown in manufacturing," said Marc Ostwald, global strategist at ADM Investor Services.

Across the euro zone, 10-year bond yields were down 6-8 basis points on the day .

Germany's benchmark 10-year bond yield fell to -0.59% -- its lowest level since the Sept. 12 European Central Bank meeting that concluded with rate cuts and fresh asset purchases to boost weak growth.

It was on track for its biggest one-day fall since June 18, when a speech by ECB chief Mario Draghi in Portugal flagged the need for stimulus and set bond yields tumbling.

Rishi Mishra, interest rates strategist at Futures First Info Services, said he would not be surprised if the German Bund yield now returned to all-time lows around -0.70%.

A long-term measure of the market's euro zone inflation expectations meanwhile fell to around 1.21% -- its lowest since early September.

Spanish bond yields received an additional boost from a credit ratings upgrade after Friday's market close.

Spain's 10-year bond yield fell 8 bps to just 0.154% , outperforming euro zone peers.

S&P Global Ratings lifted Spain to A from A-, citing economic resilience and an improving budgetary position and changed the rating outlook to stable from positive.

Rival ratings agency DBRS also changed the outlook on Spain's rating to positive from stable, which suggests the next move could be an upgrade. It rates Spain at A.

Jim McCormick, global head of desk strategy at NatWest Markets, said Spain's average ratings score is now the highest in seven years.

"Spains fundamentals already look more semi-core than peripheral," he said. "Importantly, this is slowly bringing Japanese investors into the market in bigger size."

Outgoing ECB chief Draghi speaks to the European Parliament later in the day. His comments are likely to be scrutinized closely after the weak PMI data.

(Reporting by Dhara Ranasinghe, Editing by Angus MacSwan)