UPDATE 1-Italian bond yields edge down, spotlight on budget talks

Italian government bond yields were lower on Tuesday, as tension among top government officials over the 2019 budget failed to hurt sentiment towards the market for now.

Financial markets remain on edge about the government's spending plans, and a meeting of ministers on Monday to discuss the 2019 budget saw friction building once again inside the governing coalition.

No final decisions were taken and talks will continue in the coming days, a government source told Reuters. However, deputy prime ministers Luigi Di Maio and Matteo Salvini are pushing for a larger deficit than Economy Minister Giovanni Tria wants.

The source said Di Maio and Salvini sought a deficit of 2.0 to 2.5 percent to help pay for some of their main electoral promises, including the introduction of a "universal wage" for the unemployed and pension reform.

The news pushed Italian yields up to three basis points higher at the open. Ten-year yields rose to a high of 2.89 percent before easing back to 2.86 percent, down 1.6 basis points on the day.

On Monday, reports the economy minister was set on preventing the 2019 budget deficit rising above 1.6 percent of domestic output boosted Italian bonds.

Analysts said it was encouraging that the latest headlines had not prompted a larger sell-off, particularly following a La Stampa report that quoted Di Maio as saying Tria could "go home."

"It is encouraging the way BTPs are trading, it has not been a notable move given the news flow," said Michael Leister, rates strategist at Commerzbank. "The market is no longer focused on what Di Maio is saying. Salvini is emerging as a key player."

Sentiment towards Italian bonds has improved in recent weeks after top officials said the government would respect European Union rules on fiscal discipline.

On Tuesday, Scott Thiel, BlackRock's deputy chief investment officer for fixed income, said he had recently moved to a long position in Italian bonds on expectations of a market-friendly outcome to the budget discussions.

Still, trading in Italian bonds remains choppy.

The 10-year Italian bond spread over Bunds was last at 238 basis points according to Reuters data, compared with around 232 bps late Monday.

"The market is beholden to headlines and there is a clear tension between the main parties driving these and how they will get there," said Matthew Cairns, rates strategist at Rabobank. "The spread over Bunds will remain choppy until we get something concrete."

Expectations of heavy bond supply put some upward pressure on eurozone yields, but that was largely offset as renewed trade tensions between the United States and China supported demand for safe-haven assets.

Yields across core bond markets hovered near flat, U.S. 10-year yields stayed close to 3 percent.

Germany, meanwhile, sold 3.1 billion euros of 2-year notes on Tuesday with a bid-to-cover ratio of 2.4 pct.

Germany's Bund yield came off Monday's more than six-week highs of 0.473 percent to trade at 0.447 pct.