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* Italy-Germany yield spread narrowest in three weeks
* U.S.-Germany spread near 1-month high as Fed rate hike looms
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices, adds Greece)
By Abhinav Ramnarayan
LONDON, June 13 (Reuters) - Italian government bonds were in demand again on Tuesday after the threat of snap elections receded and anti-establishment party 5-Star Movement suffered a setback in local elections.
Italy's borrowing costs dropped to multi-month lows, the bond yield spread over Germany was at its narrowest in nearly three weeks and the country's debt agency sold 5.5 billion euros of bonds in an auction.
Political risk appeared to be waning in Italy after former Prime Minister Matteo Renzi ruled out snap elections later this year. In addition, 5-Star Movement suffered a resounding defeat in local elections, results released on Monday showed.
"The news is generally positive for risk sentiment in Europe - the tail risk (presented by Italian elections) is being displaced by six months or more, so you are looking at potentially six to nine months of carry," said Mizuho strategist Antoine Bouvet.
"So investors are willing to take on spread risk - that is, sell Germany and get into Italy."
The gap between Italian and German 10-year bond yields dropped to 171 basis points on Tuesday, the lowest in almost three weeks and well off the 201 bps it reached last week.
The yield on Italy's 10-year government bond fell more than 3 bps to its lowest since late January at around 1.97 percent.
That help push other low-rated Southern European government bond yields down: Portugal's 10-year bond yield fell to a new nine-month low of 2.93 percent, while Spanish yields nudged lower.
While political risks have largely slipped down investors' worry lists since centrist Emmanuel Macron won the French presidential election, they have not completely disappeared.
In the Netherlands, a lack of progress in forming a new government since elections in March have weighed on Dutch bonds . Political turbulence in Finland has also drawn attention this week.
Finland's government averted collapse on Tuesday when the nationalist Finns Party split into two groups, leaving newly elected hardline anti-immigrant leaders in the cold.
The yield on Germany's 10-year government bond, the benchmark for the region, was up just 1 bps on the day at 0.27 percent.
Last week's decision by the European Central Bank to cut inflation forecasts and signal monetary policy will remain loose has also helped euro zone bonds, analysts said.
"You also saw the ECB cut the inflation forecasts for 2019 - the likely read through from that is that they will have to prolong the asset purchase programme," Bouvet said.
This is in sharp contrast with the United States, where policymakers are largely expected to raise rates on Wednesday and may provide more detail on plans to shrink its mammoth bond portfolio.
The "transatlantic spread" between German and U.S. 10-year borrowing costs were close to one-month highs at 195 bps as U.S. ratesetters were set to begin a two-day meeting later on Tuesday.
Elsewhere, euro zone finance ministers and the International Monetary Fund are likely to strike a compromise on Greece on Thursday, clearing the way for new loans for Athens while leaving the contentious debt relief issue for later, officials said.
Short-dated government bond yields in Greece fell to 4.896 percent, their lowest level since October 2014.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets
Additional reporting by Dhara Ranasinghe, editing by Larry King