* Cyprus set to vote on controversial deposit levy
* Bunds rally, two-year German yields turn negative
* Periphery reaction muted but contagion risk remains
By Marius Zaharia and Ana Nicolaci da Costa
LONDON, March 19 (Reuters) - Investors sought safety in low-risk German Bunds on Tuesday before a vote in the Cypriot parliament which was expected to reject a law needed to secure the island a vital bailout and avoid a default.
Cyprus's government came up with a proposal to spare small savers from a tax on bank deposits in a last-minute attempt to win parliamentary backing for the rescue, but said lawmakers still seemed likely to reject the levy.
A "no" vote would move Cyprus closer to default and a banking collapse while some analysts said a surprise approval might weigh on low-risk Bunds.
After focusing on Monday on the possible impact of the unprecedented bank levy, markets were fixated on Tuesday on the vote in Nicosia.
"There's no coherent obvious way out of the current mess. There are risks to every possible pathway coming out of the Cypriot problem," said Chris Scicluna, head of economic research at Daiwa Capital Markets.
"If the parliament approves the measures there will be relief. At least we're going somewhere. Not knowing where we're going is more unsettling than persevering with (the levy)."
Bund futures rose 71 ticks on the day to 144.65, with cash 10-year German yields falling 6 basis points to 1.346 percent. Two-year German yields turned negative for the first time since early January and last traded 2.4 bps lower on the day at minus 0.002 percent.
That meant market participants were willing to pay Germany to keep their cash for two years as they were more concerned about the safety of their investment than the return on it.
"Markets are waking up to the fact that this is all quite serious ... A classic risk-off panic scenario," one trader said.
The longer-term concern was that savers in other indebted euro zone countries might begin to feel threatened and move their money elsewhere, despite the bloc's leaders repeatedly saying Cyprus was a unique case.
"The risk of contagion remains. (The move) weakens these same (bank deposit) guarantees throughout the euro zone," Richard McGuire, rate strategist at Rabobank, said.
"Even if it doesn't spark wider market tensions now, once these begin to return, this episode will act as an accelerant of crisis tensions and will raise the risk they have a more self-fulfilling effect."
The market reaction in the lower-rated euro zone states to the proposed Cyprus bailout package has been relatively muted, with some analysts saying the market remains insulated by the European Central Bank's as yet untested bond-buying promise.
Italian 10-year yields were 9.8 basis points higher at 4.73 percent, some 12 basis points higher than last week's close. Spanish 10-year yields were 6 bps higher at 5.05 percent, also 12 bps up from Friday.
"The backstop is still there," said Michael Leister, rate strategist at Commerzbank, adding though that he still favoured German Bunds.
Analysts warned, however, against taking the relative resilience of peripheral markets as a sign that they were insulated from Cyprus contagion risks. Italy, in particular, remains vulnerable as it still struggles to form a government after last month's inconclusive elections.
"If we get some unfavourable political developments in Italy then what's come out at the weekend's Eurogroup will add pressure on the country. Equally any bad news out of Spain will be treated now more warily," Daiwa's Scicluna said.