By Ana Nicolaci da Costa
LONDON, Oct 14 (Reuters) - Lower-rated euro zone debt rose and German yields held near three-week highs on Monday, as markets remained confident the United States would resolve its fiscal stalemate despite a setback over the weekend.
Italian, Spanish, Portuguese and Irish bond yields fell as unwavering optimism regarding a potential U.S. deal supported appetite 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 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".
"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 Italian government bond yields were 2.6 basis points lower at 4.26 percent and Spanish yields were 2 bps lower at 4.28 percent. Ten-year Portuguese yields were 2.8 basis points lower at 6.27 percent - not far from a near 4-month low hit on Friday.
Italy's borrowing costs were sharply lower at a sale of up to 6 billion euros of bonds last 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.
Spain will sell three- and five-year bonds.
"Peripheries traded quite well last week given the amount of supply so I think we expect that to continue for now," one trader 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."
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 3 ticks lower at 139.76.
Jacq expected German yields to trade in a tight trading range around 1.85 percent this week, with markets likely to be choppy albeit in tight ranges.
"The probability of an event is very low but if it materializes then consequences would be massive. This can prevent the market from taking any direction but volatility is likely to push higher over the coming days," he added.
Michael Leister, senior interest rate strategist at Commerzbank expected an actual resolution to the U.S. fiscal crisis also to impact the market.
"We are getting closer to the (deadline) so pressure is building up. At the same time, there is the possibility that we get 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 1.95 percent, he said, but the rise would be capped at 2 percent.