U.S. Markets closed

German yields hold near highs, U.S. debt deal still expected

By Ana Nicolaci da Costa

LONDON, Oct 14 (Reuters) - German bond yields held near three-week highs on Monday as markets stayed confident the United States would resolve its fiscal stalemate despite a setback over the weekend.

Bipartisan talks to bring the crisis to an end broke down on Saturday in the House of Representatives and shifted to Senate leaders. Senate talks showed signs of progress on Sunday, but there were no guarantees the shutdown would end or that a historic debt default would be avoided.

The U.S. government has been partially shut since Oct. 1 and faces an Oct. 17 deadline to raise its borrowing limit or be cast into what the head of the International Monetary Fund has said would be "massive disruption".

Trade was expected to be thin with U.S. Treasury markets closed for Columbus Day.

"We had this setback over the weekend but we know that going into the end of the week ... the market remains convinced ... there will be an agreement," Patrick Jacq, European rate strategist at BNP Paribas, said.

Ten-year German yields were little changed on the day at 1.86 percent - not far from a near three-week high of 1.89 percent hit on Friday. German Bund futures were 7 ticks lower at 139.72.

Jacq expected German yields to trade around 1.85 percent this week and said the U.S. impasse would provide an excuse for investors to cash in on recent gains made on the euro zone periphery after solid bond sales last week.

"I think there will be time for some profit-taking and clearly the situation in the U.S. could offer some pretext for that to happen," Jacq added.

Ten-year Italian bond yields were up 1 basis point at 4.30 percent and the Spanish equivalent were flat at 4.31 percent.

Italy's borrowing costs were sharply lower at a sale of up to 6 billion euros of bonds on Friday, rounding off a week of hefty debt sales in Rome and Madrid which drew robust interest.

The solid auctions highlighted the improved sentiment towards the euro zone's debt-ridden southern economies, which is likely to support a Spanish sale this Thursday.

But one trader said the scope for a sell-off in lower-rated debt was also limited given the confidence on a last-minute U.S. debt deal.

"Peripheries traded quite well last week given the amount of supply so I think we expect that to continue for now," he said.

"We think periphery will continue to grind tighter over the week. We have a little bit of Spanish supply to contend with but we think it will be fairly small in size."

Spain will sell three- and five-year bonds on Thursday.