* Bund yields highest in nearly a month on U.S. deal bets
* German two-year bond auction strongly bid
* Bund reaction to Senate deal muted in after-hour trading
By Ana Nicolaci da Costa and Marius Zaharia
LONDON, Oct 16 (Reuters) - German yields rose to theirhighest levels in almost a month on Wednesday, as bets theUnited States would avoid default were reinforced after theSenate agreed to raise the debt limit and reopen the government.
U.S. Senate Democratic leader Harry Reid and SenateRepublican leader Mitch McConnell announced a bipartisan deal,which will avoid a U.S. default. The move is expected to beapproved later in the day by the Republican-led House ofRepresentatives.
"It might bring some pain relief but it will not be amulti-year grand fiscal bargain," Societe Generale ratestrategist Ciaran O'Hagan said before the announcement.
Bund futures, which usually find support in timesof uncertainty as they are considered low-risk assets, settled33 ticks lower at 138.91 before the deal was announced. Cash10-year German yields hit their highest in nearlya month at 1.945 percent earlier.
Interest rates on U.S. Treasury bills due in late Octoberthrough early November extended their earlier decline onWednesday after the announcement.
"It's not the optimal deal ... and it must have beensomewhere in the price that we were going to get a solution, sothat's why we've had the slightly muted response so far," onetrader said.
The deal would extend U.S. borrowing authority until Feb. 7,although the Treasury Department would have tools to temporarilyextend its borrowing capacity beyond that date if Congressfailed to act early next year. It would also fund governmentagencies until Jan. 15.
SHAKY SHORT-TERM DEBT
While there was no sign of panic in global financial marketsin broad terms, some areas were still showing caution.
Yields on Treasury bills maturing on Nov. 29 were at 0.12 percent, off a 0.26 percent highon Friday but still higher than 0.01 percent in late September.
One-month Treasury bills that come due on Nov. 7 yielded 0.22 percent. That was off 0.36 percent last week -their highest since the 2008 financial crisis - but still above just 0.03 percent at the end of last month.
The fact that Treasury bill yields had not fully retracedtheir recent rise suggested investors remained nervous.
Investors earlier used a two-year German bond auction as anopportunity to hedge against the so-called "tail risk" - a tiny possibility of a U.S. default.
Germany sold 4.24 billion euros of bonds at prices abovethose in the secondary market as demand measured by thebid/cover ratio rose to 2.3 from 1.6 at a previous auction.
"This is a strong auction result, with it likely havingbenefited from safe haven-type demand on the back of theuncertainty about the political situation in the United States,"Rabobank rate strategist Lyn Graham-Taylor said.
Other euro zone bonds were broadly steady.
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