By Emelia Sithole-Matarise
LONDON (Reuters) - Italian bonds rallied on Thursday after solid debt sales this week and as signs Washington was moving towards breaking a stalemate over debt and averting a potential U.S. default underpinned demand for riskier assets.
Italy outperformed the rest of the euro zone debt market, with top-rated German Bunds on the back foot after a Republican leadership aide said U.S. Republicans were considering a short-term hike in the government's borrowing authority to buy time for talks on broader policy measures.
House Republican leaders will visit the White House on Thursday as the search for a way to break the impasse continues.
Rome followed up a robust syndicated sale of 5 billion euros of a new seven-year bond on Wednesday with an 8.5 billion euro auction of one-year Treasury bills. It drew healthy appetite, with yields falling to their lowest in four months.
Spain had a similar solid result with its sale on Wednesday of 31-year paper, its first ultra-long debt sale since 2009.
Italy will offer a further 6 billion euros of bonds on Friday, capitalizing on a relief rally as concerns about political instability wane after the government won a confidence vote last week.
"Demand for the debt sales was pretty impressive. Distribution of syndicated deals looked pretty healthy," said Harvinder Sian, a rate strategist at RBS.
"The market has taken on the duration, the high 31-year issuance in the periphery space, got past that and is now rallying. It also does help that risk assets are rallying with the debt ceiling debate looking less tense in the U.S."
Italian 10-year yields were 7 basis points down at 4.30 percent, squeezing their premium over Bunds to a two-week low of 244 bps. Equivalent Spanish yields were 1.5 bps lower at 4.32 percent.
After this week's solid debt sales, both countries will have met more than 80 percent of their borrowing needs for this year.
German Bunds tracked U.S. Treasuries down as signs a debt and budget stalemate that has kept parts of the U.S. government shut for more than a week soured appetite for safe havens.
Bund futures were last 53 ticks down at 139.71 while German 10-year yields were 5 bps higher at 1.86 percent. The U.S. 10-year T-note yield was up 4 bps at 2.70 percent.
"U.S. (investors) are coming in slowly and selling on some sort of hopes of a U.S. resolution ... In the absence of any major European news we are just following Treasuries. We are at the will of political headlines out of the U.S." a trader said.
German 10-year yields could go as high as 1.90 percent in coming sessions, BNP Paribas strategist Patrick Jacq said, if there are signs U.S. politicians will reach a deal to raise the government's borrowing limit before October 17. If the deadline is missed, the United States could default on some debt.
Some in the market, including Sian at RBS and Commerzbank strategists, were cautious that a comprehensive resolution of the U.S. debt problem would be achieved soon.
"It's looking more constructive but I don't think it's going to be done and dusted given the fact that they are talking about kicking the can down the road ... and we will be up to our ears in (U.S.) economic data that has built up," Sian said.
(Editing by Catherine Evans)