* Italy-Germany bond yield spread at narrowest in three weeks
* U.S.-Germany spread near 1-month high as Fed rate hike looms
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Writes through)
LONDON, June 13 (Reuters) - Italian government bonds were in demand 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 on the wane 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 6-9 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 172.5 basis points on Tuesday, the lowest in almost three weeks and well off the 201 bps level it hit last week.
In absolute terms, the yield on Italy's 10-year government bond dropped to its lowest since late January at 1.996 percent.
The positive environment saw other low-rated Southern European government bonds also track Italy's move: Spanish and Portuguese 10-year borrowing costs also edged lower on the day.
While political risks have largely slipped down investors' worry lists since centrist Emmanuel Macron won the French presidential election, they have not completely disappeared.
Finnish 10-year bond yields rose 2 bps to 0.35 percent, following news that Prime Minister Juha Sipila will break up his three-party coalition, saying he wanted to eject the nationalist Finns Party.
Dutch equivalents rose 1.6 bps to 0.49 percent on a lack of progress towards forming a government since an election in mid-March.
The yield on Germany's 10-year government bond, the benchmark for the region, was up 2 bps on the day at 0.275 percent.
"You also saw the ECB cut the inflation forecasts for 2019 - the likely read through from 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 hike rates on Wednesday and to potentially provide more detail on its plans to shrink the 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.
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(Editing by Richard Balmforth and Ed Osmond)