* Last-minute U.S. budget deal cools demand for low risk debt
* Italian 10-yr yields at lowest in just over 2 years
* German 2-yr debt sale covered but demand weaker vs pvs auction
* Focus turning to U.S. debt ceiling talks in coming weeks
By Emelia Sithole-Matarise
LONDON, Jan 2 (Reuters) - German Bunds dropped on Wednesday after U.S. lawmakers approved a deal preventing a round of automatic tax hikes and spending cuts that had threatened to tip the world's largest economy into recession.
The Republican-controlled House of Representatives approved late on Tuesday a bill that will raise taxes on top U.S. earners, fulfilling President Barack Obama's re-election pledge and avoiding a 'fiscal cliff' of $600 billion in broad-based tax hikes and spending cuts.
The last minute deal spurred a rally in riskier assets such as equities and peripheral euro zone debt, driving Italian 10-year yields to their lowest levels in just over two years.
Although Germany managed to sell 4.15 billion euro of two-year bonds, demand was weaker than at a previous auction of the zero interest rate-bearing debt.
"The fact that the U.S. made an agreement to avoid the fiscal cliff was a trigger for some risk appetite so it was not the best day to auction German bonds but the result was not that poor," said Patrick Jacq, a strategist at BNP Paribas.
The Bund future was last 153 ticks down on the day at 144.11, near a 1-1/2 week low while cash 10-year Bunds yielded 1.43 percent, up 13 basis points.
Bunds slightly underperformed U.S. Treasuries, with the 10-year T-note yielding 39 bps over their German counterparts versus 42 bps in late European trade on Monday. U.S. and European markets were shut for New Year on Tuesday.
Strategists and some traders said Treasuries could resume their underperformance of Bunds when the U.S. session gets underway.
The sell-off in safe-haven U.S. and German bonds was, however, likely to fizzle out in coming weeks as focus turns to fresh talks on raising the U.S. debt ceiling to allow the government to continue borrowing, traders and strategists said.
"Treasuries could even underperform (Bunds today)," said Rainer Guntermann, a strategist at Commerzbank.
"But we also have the follow-up debate on the debt ceiling which we are bumping into in February and this will be another debate for the next few weeks which could possibly be supportive for Bunds."
Among lower-rated euro zone debt, Italian 10-year bond yields were last 18 bps down at 4.33 percent, having hit a trough of 4.312 percent earlier, the lowest since November 2010. The Spanish equivalent was 13 bps lower at 5.14 percent.
"The (U.S.) deal aids risk markets and should help to stabilise semi-core and periphery markets this week but supply is quickly likely to regain the focus and we expect some tactical widening into issuance, but ultimately expect that this issuance will be taken down well in January," RBS strategists said in a note.