UPDATE 1-Budget debate, election talk take shine off Spanish bonds

Spain's 10-year bond yield dipped on Tuesday alongside southern European peers but held above recent 10-month lows in a sign of some caution among investors ahead of a budget vote this week and growing talk of a possible early election.

Outside the periphery, the bloc's 10-year bond yields edged up as a deal to avert a U.S. government shutdown lifted stocks and dented demand for fixed income. The spotlight fell on Spain, where Prime Minister Pedro Sanchez was reported on Monday to be considering a snap election for mid-April, as the government scrambles to find support to get its 2019 budget through parliament.

Sanchez's party depends on the vote of smaller parties, including Catalan nationalists, who have said they will vote against it. The budget is expected to be debated on Tuesday, followed by a vote on Wednesday. To complicate matters, 12 Catalan secessionist leaders went on trial at Spain's Supreme Court on Tuesday over their role in a failed 2017 independence bid.

"Passing the budget won't be easy and there is a risk of early elections, so recent developments in Spain have been a bit of a wake-up call for markets," said Michael Leister, rates strategist at Commerzbank. "Also keep in mind that SGBs (Spanish government bonds) have performed well over the past week so the political noise is not helping."

Spain's 10-year bond yield was two basis points lower at around 1.23 percent, but holding above 10-month lows hit earlier this month at 1.19 percent. In contrast, Italian 10-year bond yields were down five bps and Portuguese yields fell three bps. The difference between Spanish and Italian 10-year bond yields has narrowed to around 161 bps, having hit 178 bps last week -- the widest in over two months -- on concerns about Italy's economic outlook.

Analysts said the relative strength of the Spanish economy meant that any fallout from election risks should be limited. Pictet Wealth Management economist Nadia Gharbi noted a big divergence in growth forecasts for Spain and Italy. She expects Spain to grow 2.1 percent in 2019 and Italy just 0.3 percent.

"It's still not clear if there will be early elections in Spain," she said. "So far there is a limited reaction in markets, because economic conditions are still strong." Italy's economy slipped into recession late last year and data suggests the outlook remains weak.

While Italian bonds benefited from a rally in risk assets, Germany's 10-year Bund yield edged away from more than two-year lows hit on Friday. The Netherlands meanwhile was due to sell a new 10-year bond. (Reporting by Dhara Ranasinghe, Editing by William Maclean and John Stonestreet)

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