* Bunds track Treasuries up as Republican proposal stumbles
* Last minute U.S. compromise still expected
* Safe-haven debt rally seen capped with year end looming
* Italian budget vote, Monti steer on elections eyed
By Emelia Sithole-Matarise and Alistair Smout
LONDON, Dec 21 German Bunds rose on Friday as investors favoured low risk government debt after the latest twist in U.S. budget talks raised the chances of a fiscal crunch next year that could tip the economy into recession.
Republicans in the U.S. House of Representatives surprisingly failed to muster enough support to pass a proposal to avert the series of tax hikes and spending cuts that are due to come into effect in about two weeks.
Bund futures gained 25 ticks to 144.53, extending Thursday's rise, as U.S. stock index futures signalled a sharply lower open on Friday, with futures for the S&P 500 down 1.4 percent.
"We can probably keep this bid in through to the weekend," a trader said. "On the basis that equities could have a tougher session, Bunds and core bonds should benefit. Peripheral yields are higher, so it's a generally risk-off day on the back of the fiscal cliff."
German benchmark 10-year yields were 2 basis points down at 1.40 percent, while in lower-rated euro zone bonds, Spanish yields rose 5 bps to 5.29 percent.
German yields were, however, unlikely to end the year significantly lower from present levels, with traders and strategists still expecting a last-minute compromise in the U.S. negotiations.
"At the end of the day this could be good news as market reaction is quite negative on the latest failure to make progress. This will probably put pressure on politicians to achieve an agreement, even if it's not a complete agreement," Patrick Jacq, a strategist at BNP Paribas, said.
"So the rally in the govvies sector could be capped shortly. For the 10-year Bund, 1.35 percent is probably the level around which it could end the year."
Traders were also watching events in Italy, where legislators are expected to vote on the country's 2013 budget that will pave the way to elections in February.
Outgoing technocrat Prime Minister Mario Monti is expected to announce at the weekend that he will participate in some way, either by endorsing parties that want him to return as premier or that he will run as a candidate.
Markets are keen for Monti to play a key role in the next government to ensure the country will stay the course on budget reforms that have eased investors' fears it could be pulled back into the centre of the euro zone debt crisis.
Italian 10-year yields were last 6 basis points up at 4.48 percent with Commerzbank strategists saying the country's last debt auction of the year on Dec. 28 could prompt some investors to book profits after the market's recent sharp rally.
Concern over delays by Spain in triggering European Central Bank bond buying could add to uncertain going into the Italian vote, ratcheting up yields, some strategists said.
"I don't see any pre-emptive voluntary bond buying request from Spain before the Italian elections. So I see a lot of uncertainty," said Nicholas Spiro, managing director of Spiro Sovereign Strategy.
"Do I see the threat of an escalation in market tensions. At this stage no. We're not going to see the self- fulfilling debilitating panic."