* German Bunds rise with deal on U.S. budget talks elusive
* Benchmark Italian debt turns flat after bond sale
* Liquidity thin between Christmas, new year holidays
By Marius Zaharia and Ana Nicolaci da Costa
LONDON, Dec 28 (Reuters) - German Bunds rose on Friday as investors sought safe-haven assets before a last-chance round of talks in the United States aimed at averting a fiscal crisis next year.
In Italy, government bonds erased minor early losses after a sale of nearly 6 billion euros of five- and 10-year debt went smoothly.
The focus was on developments in Washington where President Barack Obama was due to meet lawmakers at 3:00 p.m. EST (2000 GMT) to try to revive efforts to avoid tax hikes and spending cuts - together worth $600 billion - that will begin to take effect on Jan. 1.
With the clock ticking, investors preferred to keep their money in the safest and most liquid assets, such as Bunds and U.S. Treasuries.
Bund futures were last 20 ticks higher on the day at 145.74, while German 10-year cash yields dropped 1.7 basis points to 1.30 percent.
“The outcome (of U.S. budget talks) is still very uncertain,” said Daiwa Capital Markets economist Emily Nicol, adding that safe-haven asset prices would have risen more strongly if most investors had not already closed their books for the year.
“I reckon you’ll see a more negative reaction when investors come back.”
The market was still pricing in the likelihood of a U.S. deal in early January that would imply a fiscal tightening in the magnitude of 1 to 1.5 percent of gross domestic product, Commerzbank rate strategist Rainer Guntermann said.
In this case, 10-year German yields could rise to 1.40 percent, he said. In the absence of a deal, Guntermann said 10-year yields would 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.
In Italy, even though borrowing costs at a debt auction rose slightly compared with a previous auction, they were below those in the secondary market, a sign of healthy demand, despite growing nervousness about the impact for policy of an election due in February.
“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 -- the outgoing technocrat Prime Minister, with whom markets feel comfortable -- has said he would consider seeking a second term 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).”