* Italian yields break below key psychological levels
* ECB cash supports market but effect seen limited
* Spain finds good demand at 4.5 bln euro bond sale
By Alessandra Prentice and Kirsten Donovan
LONDON, March 1 (Reuters) - Italian two-year bond yields slipped below two percent on Thursday, their lowest level in fifteen months, as a flood of cheap ECB funding boosted appetite for peripheral debt which also led to strong demand at a Spanish debt sale.
An additional half trillion euros of three-year European Central Bank funds was added to the financial system on Wednesday, briefly pushing German bund futures to an all-time high of 140.28 as the extra liquidity underpinned core and most peripheral euro zone debt prices.
Appetite for shorter-dated Italian bonds, which were the biggest winners on Wednesday, remained robust with yields on two-year paper falling to 1.89 percent, their lowest since November 2010, due to a high Italian uptake of ECB funds, traders said.
Ten-year yields also fell, dropping below 5 percent - over two percentage points lower than their peak late last year - after Italian banks took 139 billion euros ($185.94 billion) in three-year ECB loans on Wednesday, out of a total of 530 billion euros.
"The main reason behind the sharp two-year Italian yield fall is that Italian banks were one of the biggest (participants) in the LTRO yesterday so the spread between Italy and Spain on the 2-year (bond yields) inverted -- it's a distortion," a London-based trader said.
Italian two-year bonds had yielded more than the Spanish equivalent since August last year, but dipped below them on Tuesday and were last around 40 basis points lower.
Spanish bond yields also fell, although they underperformed Italian debt, and a 4.5 billion euro sale of shorter-dated bonds s drew healthy demand.
But analysts had doubts whether the rally could continue for much longer given the myriad of problems in the euro zone yet to be addressed.
"We expect further tightening in cross-country spreads in the coming weeks and a "positive" outcome of this week's EU summit might also be supportive," said Annalisa Piazza, market economist at Newedge Strategy in London.
"However, we rule out that the extent of the tightening movement will be massive as fundamentals are not so favourable, with risks of a deep recession still looming on the EMU periphery."
Excess liquidity also benefited French bonds with the spread of 10-year French government bond yields over Bunds narrowing 11 basis points to 106 basis points , also helped by a successful 8 billion euro auction.
German Bund futures extended losses as Italian and Spanish bonds rallied to stand 45 ticks lower on the day at 139.44 with 10-year yields rising 4 basis points to 1.86 percent, around the middle of this year's trading range.
The safe-haven debt was set to remain well supported however as the market refocused on economic fundamentals and the Greek bailout process.
Traders said the recent collapse in yields at the short end of the Italian curve may have gone too far and some were anticipating investors start taking profits after the recent rally.
"Some accounts are getting in some trades just waiting for the curve to flatten. They are expecting some profit-taking on the 2-year and 3-year paper, which is looking super expensive," the trader said.
Meanwhile, The International Swaps and Derivatives Association, the arbiter of rules governing the sale and use of credit default swaps meets on Thursday to determine whether Greece's debt swap should be considered a credit event as a deadline for bondholders to agree to the process looms .
Credit default swaps help insure holders of debt against the risk of default. (Editing by Nigel Stephenson)