By Axel Bugge

LISBON, April 30 (Reuters) - Spain's deteriorating economy has made Portugal's job of riding out its debt crisis harder as its main trading partner slides into recession and the threat of contagion across the Iberian peninsula intensifies.

Portugal has seen relatively positive news in recent weeks, with bond yields falling and the country winning strong marks from official lenders to its 78-billion-euro bailout.

But as the euro zone debt crisis flares up again after several months of calm, this time with the epicentre in Spain, Portugal's economic challenges could increase as the worst recession in decades gives rise to sweeping austerity.

"With 20 percent of Portuguese exports going to Spain, any kind of slowdown will be aggravated this year due to the austerity measures in Spain," said Rui Barbara, asset manager at Banco Carregosa. "If you eventually need external help (for Spain), you could also get contagion."

Data released on Monday showed that Spain, the euro zone's fourth largest economy, dipped back into recession in the first quarter, raising pressure on Madrid in its efforts to trim the budget deficit. Spain's troubles jumped into focus last week as Standard & Poor's downgraded the country's creditworthiness two notches to BBB+.

For Portugal, which spent much of last year fending off the negative impact of the Greek crisis, a renewal of the euro zone crisis so close to home could not have come at a worse time as the government rushes to quash concerns it will need an extension of its current bailout.

"This is bad news for Spain and bad news for Portugal," said former Finance Minister Luis Campos e Cunha, referring to the downgrade of Spanish debt. "In fact, it all points to there being an extension of the bailout agreement for Portugal."

Portuguese bond yields have fallen in recent weeks but the country remains the second-most risky euro zone member after Greece, in terms of bond spreads. Portugal was the third euro zone country to seek a bailout, after Greece and Ireland.

Portugal's government has repeatedly denied it needs more money or more time to meet the goals of its bailout, which currently envisage its return to raising finance in bond markets in the third quarter of next year. The government is adamant about meeting tough fiscal goals, which it has done so far.

DEEPEST RECESSION SINCE 1970S

The economy is expected to shrink 3.3 percent this year - the biggest slowdown since the 1970s - and return to slight growth of 0.3 percent in 2013, according to government estimates. In 2011 the economy contracted 1.6 percent.

Spain's economy is expected to contract 1.7 percent this year and grow 0.2 percent in 2013.

Portugal launched sweeping austerity, including across-the-board tax hikes and spending cuts, last year after requesting a bailout in May. Internal demand slumped as a consequence, contracting 5.7 percent in 2011.

But exports jumped about 11 percent last year as companies turned to foreign markets to avoid the domestic slump. That rise could be dented as Spain descends deeper into recession while it enacts its own dose of austerity.

Spain's direct economic impact on Portugal extends beyond just exports. Before the crisis hit, Spain was one of Portugal's five biggest foreign investors and its citizens are the single biggest group of tourists that visit Portugal.

In addition, Spain's biggest bank Santander, is Portugal's third largest private bank.

"If you see a deepening of Spanish problems, especially in the banking sector, the fear will spread to Portugal and other countries," said Barbara.

Despite this, yields on Portuguese bonds have fallen sharply in the past few weeks after they failed to join the rally in other peripheral bond markets earlier in the year on the back of the European Central Bank's long-term liquidity operations.

Portugal's 10-year bond yields traded around 10.75 percent on Monday, sharply down from highs above 17 percent in January. Some analysts say that is because fears have subsided that Portugal could be forced to restructure its debts like Greece.

Elisabeth Afseth, fixed-income analyst at Investec Capital Markets in London, suggests falling Portuguese bond yields could in themselves be a symptom of the worsening of Spain's crisis as the euro zone may have to consider direct help for banks.

"If the problems spread to Spain, there may possibly be capital (from Europe's rescue fund) directly for banks," she said. "That might help all countries."