(Updates with details of Barcelona rally, fresh quote, new prices)
By Jemima Kelly and Emelia Sithole-Matarise
LONDON, Sept 11 (Reuters) - Spain's 10-year bond yield premium over Italy hit its highest in over two years on Friday on worries about political instability if secessionists win an election in the wealthy province of Catalonia later this month.
Hundreds of thousands of people began massing in the streets of Barcelona on Friday to call for the northeastern region to break away from the rest of Spain as official election campaigning began in the province, which accounts for nearly one fifth of Spain's output and population.
Spanish bonds have underperformed Italian peers in the run-up to the Sept. 27 regional ballot, which separatists want to use as a proxy vote on independence.
That is fiercely opposed by Spain's centre-right prime minister, Mariano Rajoy, whose re-election bid in December could be complicated by events in Catalonia.
Latest polls suggested that pro-independence parties could win a majority of seats, but not the absolute majority of votes that could give their campaign a powerful boost.
"We think fears of an imminent break-up of Spain stemming from the Catalan election are overstated ... so we're relatively relaxed about that," said Rabobank strategist Lyn Graham-Taylor, adding that he thought any further spread widening would be limited to 10 or 15 basis points.
"But the flip-side is: we don't see this as a buying opportunity either because of the very unclear outlook on the elections in December."
Concerns around Spanish politics helped spur demand at Italy's bond auction, where the Treasury raised its targeted 7.75 billion euros and paid lower yields on all three maturities sold.
Italian 10-year yields dipped 1 basis point to 1.84 percent while Spanish equivalents were 2 bps higher at 2.11 percent, widening the gap to 28 basis points, the most since mid-August 2013.
IRISH RATINGS
Investors were also looking to a potential upgrade by Moody's of Ireland's credit ratings after the market close. Irish 10-year yields were 1 basis point lower at 1.31 percent.
"It is definitely conceivable that at least the outlook will be upgraded to 'positive'. The current 'Baa1' rating makes Moody's the last of the three major rating agencies to not yet have assigned a rating in the "A" category to Ireland," DZ Bank strategists said in a note.
"The return of Irish bonds to the core segment ought to continue and even accelerate in the form of noticeable spread narrowing in the coming weeks."
German 10-year yields, the euro zone benchmark, were down 4 basis points at 0.66 percent on growing doubts that the U.S. Federal Reserve would raise interest rates next week. U.S. consumer sentiment dropped to its lowest level in a year in September, reinforcing those doubts.
(Editing by Kevin Liffey)