Conditions attached to a 78 billion euros bailout of Portugal's debt-ridden economy are likely to propel it into a deep recession for two years, an official source said on Wednesday.

Caretaker Prime Minister Jose Socrates announced late on Tuesday the country had reached a three-year bailout agreement with the European Union and International Monetary Fund after weeks of negotiations with the third euro zone country to seek foreign assistance, after Greece and Ireland.

European Union and IMF officials were due to meet Portugal's main opposition on Wednesday to secure its agreement for the bailout terms, with elections due in a month.

Socrates said the agreement represented a victory for Lisbon, as it avoided very tough measures which Greece and Ireland were saddled with when they were bailed out last year.

But an official source told Reuters the austerity measures to be included in the deal, such as higher taxes, point to a contraction of 2 percent in gross domestic product in 2011 and in 2012.

That will make it yet more challenging for the heavily indebted country, which has had some of the lowest growth rates in Europe for a decade, to ride out its crisis and return to financial health.

The source told Reuters taxes will rise on cars and property and there will be cuts in deductions on health, education and housing.

Jonathan Loynes, chief European economist at Capital Economics, also forecast a two percent contraction this year.

Against this background, while the confirmation of the bailout should provide some reassurance that Portugal will be able meet its upcoming bond redemptions, it won't put an end to speculation that -- along with Greece and perhaps others -- it will sooner or later need to undertake some form of debt restructuring, he said.

The announcement of the deal did provide some relief in the bond market, where Portuguese yields fell for the first time in many weeks.

Yields on Portuguese 10-year bonds, which hit a euro lifetime record of 10.32 percent on Tuesday, fell to around 10 percent and the spread to German Bunds fell to 677 basis points from Tuesday's highs of 707.

Portugal was forced to seek a bailout after its government collapsed last month, sending its borrowing costs soaring.

In a reminder of the challenges Portugal faces in selling debt, it will hold a treasury bill auction on Wednesday to issue up to 1 billion euros of 3-month bills.

DEFICIT GOALS EASED

Lisbon won some leeway for its austerity drive from its lenders. This year's budget deficit target was raised to 5.9 percent of gross domestic product from 4.6 percent previously.

That still represents a sharp cut given the deficit totaled 9.1 percent of GDP last year and, under the deal, it must be lowered to 4.5 percent of GDP in 2012 and 3 percent in 2013.

The bailout deal includes up to 12 billion euros for the banking sector to recapitalize and orders banks to raise their core Tier 1 capital ratios gradually to 10 percent by the end of 2012, the official source said.

It also envisages 5.3 billion euros in privatization revenues until 2013.

The package will need broad cross-party support because the collapse of Socrates' government last month means the winner of a June 5 snap general election will implement it.

Opposition Social Democrat leader Pedro Passos Coelho was due to meet with officials from the EU and IMF later.

The interest rate on Portugal's bailout loan is expected to be set at a meeting of euro zone finance ministers in mid-May.

Even though we have clarity regarding the amount, the more interesting detail will be the interest rate that Portugal will have to pay on the loans so we are still waiting for this, said WestLB rate strategist Michael Leister.

Portuguese agreement to the loan terms is needed by June 15, when Lisbon has to redeem 4.9 billion euros of bonds.

Officials from the European Commission, the International Monetary Fund and the European Central Bank have been in Lisbon for almost a month to hammer out the agreement.

(Reporting by Sergio Goncalves; writing by Axel Bugge, editing by Mike Peacock)

Portugal International Monetary Fund