By Ana Nicolaci da Costa
LONDON, Oct 14 (Reuters) - Lower-rated euro zone debt roseand German yields held near three-week highs on Monday, asmarkets remained confident the United States would resolve itsfiscal stalemate despite a setback over the weekend.
Italian, Spanish, Portuguese and Irish bond yields fell asunwavering optimism regarding a potential U.S. deal supportedappetite for risk. But trade was range-bound and thin with U.S.Treasury markets closed for Columbus Day, traders said.
Bipartisan talks to bring the U.S. fiscal crisis to an endbroke down on Saturday in the House of Representatives andshifted to Senate leaders. Senate talks showed signs of progresson Sunday, but there were no guarantees the shutdown would endor that a historic debt default would be avoided.
The U.S. government has been partially shut since Oct. 1 andfaces an Oct. 17 deadline to raise its borrowing limit or becast into what the head of the International Monetary Fund hassaid would be "massive disruption".
"We had this setback over the weekend but we know that goinginto the end of the week ... the market remains convinced ...there will be an agreement," Patrick Jacq, European ratestrategist at BNP Paribas, said.
Ten-year Italian government bond yields were2.6 basis points lower at 4.26 percent and Spanish yields were 2 bps lower at 4.28 percent. Ten-yearPortuguese yields were 2.8 basis points lower at6.27 percent - not far from a near 4-month low hit on Friday.
Italy's borrowing costs were sharply lower at a sale of upto 6 billion euros of bonds last Friday, rounding off a week ofhefty debt sales in Rome and Madrid which drew robust interest.
The solid auctions highlighted the improved sentimenttowards the euro zone's debt-ridden southern economies, which islikely to support a Spanish sale this Thursday.
Spain will sell three- and five-year bonds.
"Peripheries traded quite well last week given the amount ofsupply so I think we expect that to continue for now," onetrader said.
"We think periphery will continue to grind tighter over theweek. We have a little bit of Spanish supply to contend with butwe think it will be fairly small in size."
Ten-year German yields were little changed onthe day at 1.86 percent - not far from a near three-week high of1.89 percent hit on Friday. German Bund futures were 3ticks lower at 139.76.
Jacq expected German yields to trade in a tight tradingrange around 1.85 percent this week, with markets likely to bechoppy albeit in tight ranges.
"The probability of an event is very low but if itmaterializes then consequences would be massive. This canprevent the market from taking any direction but volatility islikely to push higher over the coming days," he added.
Michael Leister, senior interest rate strategist atCommerzbank expected an actual resolution to the U.S. fiscalcrisis also to impact the market.
"We are getting closer to the (deadline) so pressure isbuilding up. At the same time, there is the possibility that weget an agreement and in that scenario, as a knee-jerk reaction,we would expect a sell-off in Bunds," he said.
That could push 10-year German yields as far as 1.95percent, he said, but the rise would be capped at 2 percent.