LONDON, July 29 (Reuters) - Spain's borrowing costs fell to a 16-month low on Friday after the government raised its growth forecasts and the conservative party said it would talk to other parties to try to break a political deadlock that has lasted more than seven months.
The acting prime minister, Mariano Rajoy, was due to call the heads of the Socialist Party and the liberal Ciudadanos on Friday to seek their support to form a government, a party spokesman said.
Spain has been without a proper government since an inconclusive election in December. Rajoy's People's Party won the most parliamentary seats at a second vote in June, but did not reach the 176 needed to govern alone.
Yet the economy has proved resilient to the political uncertainty, and Rajoy's acting government raised growth forecasts for 2016 on Friday as Spain extends its three-year recovery from a crippling recession.
Madrid's 10-year bond yields fell 6 basis points to 1.03 percent, the lowest since March 2015.
"Markets are more optimistic that he (Rajoy) will be able to gather more parties and might be able to just get a majority," said Nick Stamenkovic, a bond strategist at RIA capital markets.
"That would bring some much-needed political stability back to Spain ... and at this juncture the Spanish economy is the star performer in Europe and showing no signs of slowing."
Spanish bonds outperformed all their euro zone peers in a broad rally after weaker-than-expected growth data from the United States was seen diminishing the chances of an interest rate hike in the world's largest economy that could push up yields globally.
Analysts said signs that Spain and Portugal would be spared European Union fines for their excessive deficits were also helping demand for Spanish bonds.
Spanish bond yields are some 14 basis points lower than those in neighbouring Italy, the biggest gap since January 2015.
Over the last 18 months, Italian yields have tended to be below those of Spain, but that has reversed over the last month as concerns have started to mount about the health of Italy's banks.
Italy, whose lenders are saddled with around 360 billion euros ($400 billion) of bad debt, is expected to fare worst in bloc-wide bank stress tests due to be published after markets close on Friday.
It has four banks undergoing tests, with the third largest, Monte dei Paschi, under the most pressure. The tests are expected to show that capital levels at the bank, which is weighed down by around 50 billion euros in bad loans, are insufficient to withstand a major economic shock. (Editing by Kevin Liffey)