* Brighter economic outlook fuels flows into Spain, Italy
* Bund futures rebound after ECB-triggered selloff
* Trade cautious ahead of U.S. jobs data
By Emelia Sithole-Matarise
LONDON, March 7 (Reuters) - Spanish and Italian bond yields fell to their lowest levels in nearly 8-1/2 years on Friday after a solid debt sale in Madrid this week as an improved economic outlook in the euro zone fuelled investor demand.
Sentiment in the broader market was also stabler after a sell-off in top-rated bonds on Thursday on disappointment that the European Central Bank signalled it was in no hurry to loosen monetary policy further despite inflation running well below its target.
Money markets all but priced out prospects for further policy easing in coming months. Interbank lending rates rose even higher on Friday after data from the ECB showed banks were set to repay a big chunk of its emergency three-year loans next week, squeezing the amount of excess cash in the market.
Some analysts, however, say the ECB's pledge to maintain an accommodative policy and its insistence that it might act if economic conditions deteriorate supported flows into peripheral euro zone debt.
Spanish 10-year yields fell 6 basis points to 3.37 percent while equivalent Italian yields were 5 bps down at 3.42 percent, both back at October 2005 lows.
"The Spanish auction yesterday was taken down pretty comfortably and peripherals in general have performed very well even with jitters over Ukraine which is a reflection of the improving sentiment towards the euro area current recovery as a whole," said RIA Capital Markets strategist Nick Stamenkovic.
"As long as the economic picture in the euro area, particularly in the periphery, continues to improve and given that overseas investors are increasing exposure to peripheral markets there's another leg lower in peripheral spreads."
Spanish three- and five-year borrowing costs hit record lows at a debt auction on Thursday of up to 5 billion euros of bonds, adding to a string of solid debt sales so far this year.
With top-rated bonds such as German Bunds now offering ultra-low returns, market participants see not letup in the peripheral euro zone bond rally.
"Not just Germany, but the UK and U.S. markets don't necessarily offer great risk/reward and so (investors) look to the kind of yields you can get in Spain and Italy. You're still getting mid-3 percent and that's pretty attractive," said Andy Chaytor, head of European rate strategy at Nomura.
Elsewhere, German Bund futures rose 16 ticks to 142.34, clawing back some ground after suffering their biggest one-day fall since late December on Thursday after the ECB refrained from new stimulus measures. Cash 10-year Bund yields were 1.5 basis point lower at 1.64 percent.
Activity was, however, subdued before U.S. non-farm payrolls data that will provide insight on the state of the world's biggest economy and could influence the Federal Reserve's policy outlook.