EURO GOVT-Bunds rally as prospect of U.S. fiscal deal fades
* Bunds up along with Treasuries as Republican proposal stumbles
* Safe-haven debt rally seen capped, some bet on last-minute deal
* Italy's budget, political future in focus
LONDON, Dec 21 (Reuters) - 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.
Republicans in the U.S. House of Representatives surprisingly failed to muster enough support for a proposal that would have averted the automatic tax hikes and spending cuts due to come into effect in about two weeks.
German Bund futures gained 45 ticks to a settlement close of 144.77, extending Thursday's rise, as Wall Street dropped 1 percent.
"If they by any chance don't reach an agreement, probably we will see a lot of volatility in the beginning of next year," a trader said.
"I think they will achieve an agreement, because it is against the interests of both parties not to."
The bond rally could be capped as the end of the year approaches and as some in the market hold on to a view that a U.S. agreement will be achieved at the eleventh hour.
"I still think we're going to get some kind of deal done, so ultimately Bunds are still on a downward trend, as they're tied so closely to the fiscal cliff situation. But they're going to get kicked about all over the place before year end," David Keeble, global head of fixed income strategy at Credit Agricole said.
Failure to achieve a deal would likely give the Bund rally further momentum, but the trader said there was strong resistance at 145.00 - a 50 percent retracement from the sell-off that started this month from the highest to the low.
Patrick Jacq, a strategist at BNP Paribas, said the market reaction could increase pressure on politicians to achieve an agreement, even if not a complete one, and 10-year Bund yields would probably end the year around 1.35 percent.
Ten-year German yields were last down 3.9 bps at 1.38 percent.
Traders were also watching events in Italy, where parliament approved the 2013 budget.
Italian Prime Minister Mario Monti is preparing to hand in his resignation to the president, opening the way to an election expected in February.
The technocrat 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 saying he will run as a candidate.
Markets are keen for Monti to play a major role in the next government to ensure the country follows through on budget reforms needed to keep it out of the euro zone debt crisis.
Italian 10-year yields were last 5.7 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.
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