* Spanish, Italian bonds benefit from better risk appetite
* Italian yields back at pre-Monti resignation plan levels
* Bunds ease, bigger selloff to follow "fiscal cliff" deal
LONDON, Dec 18 (Reuters) - Spanish and Italian government bonds rallied in thin trade on Tuesday as progress in U.S. budget talks and the absence of any fresh domestic scares lifted investors demand for higher-yielding assets.
The prospect of a series of painful automatic austerity measures next year dimmed slightly when, according to a source familiar with the talks, U.S. President Barack Obama made a counter-offer to Republicans that included a change in position on tax hikes for the wealthy.
That prompted a rally in equities globally and the desire to secure returns on investment pushed some back towards the euro zone's lower-rated peripheral bonds as the effects of last week's political shock in Italy subsided.
This narrowed the yield differential with low-risk German debt.
"We're continuing to grind tighter in the absence of any negative news. As long as that continues, and equities do well, we'll continue to see peripherals do well into year-end," a trader said. "Nobody wants to miss out on the high-yielding carry trade."
Spanish debt extended gains after its final bill sale of the year raised more than the target amount. There are no long term peripheral debt sales until Italy sells bonds on Dec. 28 and the absence of supply was also supportive, traders said.
Spanish 10-year bond yields fell 7.5 basis points to 5.38 percent while the equivalent Italian debt fell 8 bps to 4.49 percent.
Italian yields moved back below levels seen before Prime Minister Mario Monti sparked a wave of selling by announcing he would resign early. Investors have since bought back into Italy on the view that any successor government will remain committed to Monti's reform agenda.
SHOW ME THE DEAL
The shift towards riskier assets spurred some investors to trim their holdings of low-risk debt such as U.S. Treasuries and German Bunds -- assets used as hedges that should rally if the U.S. budget talks do not produce a deal.
Bund futures were a fraction lower on the day, recouping most of their early losses to stand 7 ticks down versus Monday's settlement, at 144.79.
Traded volume in the Bund future was well below average at less than 200,000 lots by 1200 GMT with many long-term investors reluctant to make major changes to their positions before the new year, leaving trading dominated by more speculative players.
"Euro zone market players -- as much as they are in the market at all at this time -- want to see this U.S. deal being closed. They don't want to hear announcements," said Marius Daheim, chief strategist at Bayerische Landesbank.
"If they see that this problem is off the table, then you might expect to see a more significant move in Bund yields."
Commerzbank recommended taking short-term positions to profit from a fall in the Bund future over the course of the day, targeting the 144 area.
This strategy was also based on comments from the European Central Bank's Yves Mersch, who told a German newspaper he did not see the logic of a debate about the bank cutting its main interest rate from the current record low.