* Benchmark Italian debt turns flat after 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 German Bunds rose on Friday as a deal on U.S. fiscal budget talks remained elusive, while ten-year Italian bonds erased losses after a sale of longer-dated bonds went smoothly.
Italy sold 5.87 billion euros of five- and ten-year bonds, at the top end of a 4 to 6 billion euro range. Even though borrowing costs rose slightly, they were lower than those in the secondary market, a sign of healthy demand at the auction.
Italian borrowing costs have fallen since the European Central Bank's promise to buy bonds of struggling euro zone countries made investors more reluctant to sell them.
"It seems that the result was better than expected, with the yield on the 10-year lower than in the secondary market," said Emile Cardon, market economist at Rabobank in Utrecht.
"The biggest fear for the market is that political turmoil in Italy will return. But this outcome shows they still have confidence that Italy will do the right things and I think this has something to do with the comeback of Monti."
Mario Monti has said he would consider seeking a second term as Italian prime minister if approached by allies committed to backing his austere brand of reforms.
Ten-year Italian government bonds turned higher after the auction, having been under pressure in early trading. Yields were 1 basis point lower at 4.52 percent, having stood at 4.55 before the results.
"It was a good auction," one trader said. "It looks like there are enough buyers in the market, especially domestic (ones)."
The Treasury sold 3 billion euros of its 10-year bond paying a yield of 4.48 percent, up from 4.45 percent at a similar sale one month ago.
Rome also placed 2.87 billion euros of its five-year bond paying 3.26 percent, up from 3.23 percent at end-November sale. In the secondary market, five-year bonds yielded 3.31 percent.
U.S. FISCAL LIMBO
German Bund futures rose 16 ticks to 145.70 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," a second 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.