* Italian yields break below key psychological levels
* ECB cash to support peripheral debt near-term
* Spain finds good demand at 4.5 bln euro bond sale
* Bund futures back away from record highs
By Marius Zaharia and Alessandra Prentice
LONDON, March 1 (Reuters) - Italian two-year bond yields slipped below 2 percent to their lowest level in 15 months on Thursday, as a flood of cheap ECB funding boosted appetite for peripheral debt and also spurred 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 and is expected to continue to support a rally in lower-rated euro zone debt in the near term.
Italy's debt outperformed as its domestic banks were among the heaviest bidders for ECB cash, taking 139 billion euros of the total. Two-year yields fell to 1.73 percent, their lowest since October 2010, while 10-year yields dropped 22 basis points to 4.98 percent.
"Confidence is building," said David Keeble, global head of fixed income strategy at Credit Agricole. "We should see a further tightening of the spreads. Surely we've seen most of it and it's going to be a slower grinding now but I think we're on a good trajectory."
The massive take-up of ECB funds by Italian banks has pushed the short end of the Italian yield curve below the Spanish one. One trader called the move "a distortion" and analysts say Spanish bonds should yield less than Italian bonds based on economic fundamentals.
Spain has been under pressure after recent data showed it overshot its budget target last year and the rally in Spanish bonds also lagged because the country frontloaded its debt issuance, having now issued almost 40 percent of its 2012 goal.
A 4.5 billion euro sale of shorter-dated Spanish bonds drew healthy demand on Thursday.
THE ELEPHANT IN THE ROOM
While the rally could continue for another couple of days or weeks, analysts say sentiment could quickly turn around due to the myriad of problems in the euro zone yet to be addressed.
Newedge Strategy's market economist Annalisa Piazza said she ruled out that "the extent of the tightening in peripheral spreads over German Bunds would be massive," due to risks of a deep recession in southern euro zone states.
"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.
Greece, described by Credit Agricole's Keeble as "the elephant in the room", will remain in focus.
Even if the Greek debt swap that is currently under way is successful, Greece's economy will still look worse than Portugal, seen by many as the next country in line to restructure its debt. The new Greek bonds are thus likely to price in a high risk of another debt restructuring.
Greece has not yet triggered payment on controversial default insurance contracts, but Athens' huge debt restructuring is still expected to end up causing a credit default swap payout.
German Bund futures were last 61 ticks lower at 139.28, having fallen from all-time highs of 140.28 hit on Wednesday, when they gained in tandem with peripheral bonds.
"Liquidity lifts all boats," Keeble said. "But when the U.S. Treasury market is under so much pressure and the (U.S.) growth numbers have been coming in strong, you can't offset that entirely with extra ECB cash."
U.S. jobless claims fell by 2,000 to 351,000 in the latest week, holding near four-year lows, but the pace of growth in U.S. manufacturing unexpectedly slowed in February. (Editing by Susan Fenton)