* Spanish/German bond yield gap pulls back from 1-month highs
* Budget vote due Wednesday, election talk ramps up
* German Bund yields hold above 2-year lows
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr
By Dhara Ranasinghe
LONDON, Feb 12 (Reuters) - Spain’s 10-year bond yield held above recent 10-month lows on Tuesday, reflecting a note of caution among bond investors ahead of a budget vote this week and growing talk of an early election.
Most 10-year bond yields in the euro area edged higher as a deal to avert a U.S. government shutdown lifted stocks and dented demand for fixed income.
The spotlight fell on Spain, where Spanish Prime Minister Pedro Sanchez was reported on Monday to be considering a snap election for mid-April, as the government scrambles to find the support to get the 2019 budget through parliament.
Sanchez’s party depends on the vote of smaller parties, including Catalan nationalists, who have said they will vote against it. The budget vote is due on Wednesday.
“Passing the budget won’t be easy and there is a risk of early elections, so recent developments in Spain have been a bit of a wake-up call for markets,” said Michael Leister, rates strategist at Commerzbank.
“Also keep in mind that SPGs (Spanish government bonds) have performed well over the past week so the political noise is not helping.”
Spain’s 10-year bond yield was flat at around 1.24 percent , above 10-month lows hit earlier this month at 1.19 percent, and underperforming Italian yields, which fell 3 basis points.
The difference between Spanish and Italian 10-year bond yields has narrowed to around 160 bps, having pushed out to 178 bps last week — the widest in over two months — on concerns about Italy’s economic outlook.
Still, analysts said the relative strength of the Spanish economy compared to Italy’s meant that any fallout from heightened election risk should be limited.
Pictet Wealth Management economist Nadia Gharbi noted a big divergence in growth forecasts for the two economies. She expects Spain to grow 2.1 percent this year and Italy’s economy to expand 0.3 percent.
“It’s still not clear if there will be early elections in Spain,” she said. “So far there is a limited reaction in markets, because economic conditions are still strong.”
In contrast to Spain, Italy’s economy slipped into recession late last year and data suggests the outlook remains weak.
A stronger tone to world stocks lifted most euro zone bond yields on Tuesday, although Italian bonds benefited from the rally in risk assets.
Germany’s benchmark 10-year Bund yield was up two bps at 0.14 percent, about six bps above more than two-year lows hit on Friday.
Reporting by Dhara Ranasinghe, Editing by William Maclean