* Bunds fall with Treasuries on rising bets of a U.S. debtdeal
* German yields could spike above 2 percent if deal reached
* Spain, Italy yields stabilise after recent falls
By Emelia Sithole-Matarise
LONDON, Oct 15 (Reuters) - German 10-year yields rose totheir highest in three weeks on Tuesday as expectations of adeal to avert a potential U.S. debt default pulled investors outof top-rated government bonds and into riskier assets.
The move tracked a rise in U.S. Treasury yields after U.S.Senate Majority leader Harry Reid, a Democrat, and hisRepublican counterpart, Mitch McConnell, ended a day of talks onMonday, with Reid saying they had made "tremendous progress".
The plan under discussion would promptly end a partialgovernment shutdown about to enter its third week and raise thedebt ceiling by enough to cover the country's borrowing needs atleast through mid-February, according to a source familiar withnegotiations.
The Bund future, sought by investors as asafe-haven in times of market stress, was last down 38 ticks at139.36 with an upbeat reading of German investor sentiment dataadding to the weaker tone.
German 10-year yields were 3.5 basis points upat 1.90 percent, their highest since Sept. 23, with benchmarkU.S. yields up by a similar amount at 2.72 percent.Other higher-rated euro zone bond yields, notably Dutch,Austrian and French, were also higher on the day.
"There's hope that there will be some kind of a temporarysolution in the U.S. and that supports cautious risk sentiment,and that's been weighing on Treasuries and Bunds," said NielsFrom, chief rates analyst at Nordea.
There were, however, signs of market edginess. Interestrates on short-term Treasury bills were near their highest sincethe 2008 financial crisis. The cost of insuring against a U.S.debt default in the near-term was 29 basis points abovefive-year rates, near their most since 2011, according to dataprovider Markit.
It is normally costlier to buy longer-term creditprotection. The current curve inversion - considered a classicsign of credit stress - reflects investors' concern over apotential short-term default.
"The market still needs a deal to believe in it ... It willbe a temporary solution, not a long term solution, and will givethem time to negotiate for the next couple of months," Fromsaid.
If a deal is reached, and economic data continue to improve,some in the market expected German 10-year yields to spike tothis year's peak of 2.059 percent, hit in early September asmarkets braced for the U.S. Federal Reserve to start trimmingits monetary stimulus.
"There's been an improvement in sentiment in (euro zone)periphery (debt) and if there's an improvement in European data,core bond yields should go higher," said Alessandro Giansanti, astrategist at ING in Amsterdam.
Italian yields slipped, extending last week's falls on anupbeat tone in riskier assets and after recent solid debt salesin Rome and Madrid.
Spanish equivalents, however, bucked the trend and were lastup 3.5 bps at 4.31 percent as traders pushed forcheaper prices before another debt sale on Thursday.