* Italian debt under pressure before 5-, 10-year bond sale
* Liquidity thin between Christmas holidays, new year
* German Bunds rise as deal on U.S. budget talks elusive
By Ana Nicolaci da Costa
LONDON, Dec 28 Italian government bonds slipped on Friday as investors readied for a sale of longer-dated debt in the country's last auction of the year.
Rome will offer between 2 billion and 3 billion euros of five-year bonds and the same amount of 10-year paper.
The auction is expected to go reasonably well after heavy redemptions helped Rome sell all the bills and bonds it aimed to on Thursday.
"There should be sufficient domestic players around to cover this auction. It probably won't be stellar but it will go through in very thin overall market environment," Rainer Guntermann, strategist at Commerzbank said.
In the secondary market, ten-year Italian government bond yields were up 2 basis points at 4.55 percent, while Italian borrowing costs over five years firmed 3.7 bps to 3.29 percent.
Spanish 10-year yields followed suit, rising 2.6 bps to 5.32 percent.
Italian and Spanish borrowing costs have dropped sharply since the European Central Bank's promise to buy bonds of struggling euro zone countries made investors more reluctant to sell those bonds.
But other traders expected the Italian auction to be more of a challenge in such a thin market.
"We got a bit of a concession yesterday, but it's quite a big size for this time of year. I am a bit concerned about the size," one trader said.
U.S. FISCAL LIMBO
German Bund futures rose 24 ticks to 145.78 on Friday in thin overall volumes as investors remained firmly focused on difficult U.S. budget talks.
President Barack Obama and Vice President Joe Biden will meet congressional leaders from both parties at the White House on Friday at 3 p.m. EST (2000 GMT) to try to revive negotiations to avoid tax hikes and spending cuts - together worth $600 billion - that will begin to take effect on Jan. 1.
But after weeks of talks, investors were losing faith that a deal could be achieved before the end of the year - a prospect that would likely keep safe-haven debt supported.
"The fiscal cliff talks are breaking down again," the trader said. "I don't see why Bunds should massively sell off at this time."
In particular, any solution is likely to come later than expected and to result in some amount of fiscal tightening anyway, analysts said.
"The longer you go without any deal, the longer Treasuries and Bunds remain underpinned," Commerzbank's Guntermann said.
The market was still pricing in the likelihood of an agreement in early January that would imply a fiscal tightening in the magnitude of 1 to 1.5 percent of GDP, he said.
In this case, 10-year German yields could rise to 1.40 percent from 1.30 percent currently.
In the absence of a deal, Guntermann expected 10-year German yields to probably fall below 1.25 percent.
"Ultimately it would be a big surprise if they would allow the economy to (completely) fall off the cliff," he said.