* Last-minute U.S. budget deal cools demand for low risk debt
* Peripheral debt seen rallying; lack of supply helps
* Focus turning to U.S. debt ceiling talks in coming weeks
By Emelia Sithole-Matarise
LONDON, Jan 2 German Bunds fell on Wednesday after U.S. lawmakers approved a deal preventing a round of automatic tax hikes and spending cuts that had threatened to prod the world's largest economy into recession.
The Republican-controlled House of Representatives approved 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 prompted a rally in riskier assets such as equities to the detriment of debt, like Germany's, which has been seen as a safe haven from mounting market tensions as the U.S. negotiations dragged on last month.
The sell-off in German and U.S. government bonds was, however, likely to be limited in coming weeks as focus turns to fresh talks on raising the U.S. debt ceiling, traders and strategists said.
"The compromise ... should weigh on Bunds which should correct in line with Treasuries. Treasuries could even underperform," said Rainer Guntermann, a strategist at Commerzbank.
"But we also have the follow-up debate on the (U.S.) 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."
The Bund future was last 85 ticks down at 144.79 compared with 145.64 at Monday's close. European markets were shut for New Year's Day on Tuesday.
Cash 10-year Bunds yielded 1.39 percent, up 9 basis points on the day and some traders and strategists see them going as high as 1.45 percent in coming days.
"Bunds can sell-off back to 1.40/45 percent on the fiscal cliff deal but we want to start adding to longs here," RBS strategists said in a note.
Firming investor appetite for assets seen as higher risk prompted a rally in peripheral euro zone bonds, with the Italian 10-year bond yield last 9 bps down at 4.42 percent while the Spanish equivalent was 6 bps lower at 5.21 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," the RBS strategists said.
German kicks off 2013 debt issuance with a sale of zero coupon two-year bonds later in the day where demand could fall foul of the souring investor appetite for low-risk debt - now carrying almost zero yields for investors.