* German 10-year bund yields goes as high as 0.54 pct
German coalition agreement boosts sentiment
* Italian 10-year yields up 6 bps
* Other euro zone yields lower 1-3 bps on day (Adds quotes, updates prices)
By Abhinav Ramnarayan and Fanny Potkin
LONDON, Jan 12 (Reuters) - German bond yields hovered near recent highs on Friday as coalition progress in Germany kept upward pressure on yields after this week's bond sell-off triggered by the possibility of a European Central Bank rethink on policy messaging. German Chancellor Angela Merkel's conservatives and the Social Democrats (SPD) agreed on Friday after all-night talks to a blueprint for formal coalition negotiations, party sources said.
The news that Europe's biggest economy could end political uncertainty after a September 2017 election delivered a hung parliament boosted the euro to a three year high and pushed investors away from safe haven German bonds towards lower-rated southern European debt.
Italy's 10-year government bond yield was down 6 basis points to 2 percent and the spread over the German equivalent was at its tightest since Dec. 28 at 148 basis points at one stage.
Spanish 10-year yields were also lower on the day by 2 bps.
"There's been a out-performance today by the two ... which coincides with the news coming out of Germany," said ABN AMRO senior fixed income strategist Kim Liu.
The yield on Germany's 10-year government bond rose as high as 0.54 percent in early trade, the highest since August.
It dropped again later in the session but was still close to three-month highs at 0.52 percent, down a basis point on the day.
Meanwhile the euro climbed to a three-year high. The SPD are considered heavily pro-Europe, with leader Martin Schulz last year arguing for closer ties and calling for a "United States of Europe".
The rise in yields adds to a sell off that intensified on Thursday after minutes from the ECB's December meeting showed the bank could revisit its policy messaging in early 2018 and gradually adjust its language to reflect improved growth prospects. Analysts said the minutes were interpreted by markets as a sign that rate-setters may accelerate the timeline on winding down their 2.55 trillion euros bond-buying programme, the key plank of their stimulus policy for the past three years.
Euro zone money markets are now pricing in a 70 percent chance of a 10 basis point hike from the European Central Bank by the end of the year, ratcheting up bets on a rate rise in the wake of this week's hawkish central bank minutes.
"Markets will stay nervous until (ECB president) Draghi provides his views on the aggressive repricing and euro appreciation two weeks from now," said Commerzbank strategist Michael Leister.
Most core 10-year euro zone bond yields dropped 1-2 bps on Friday, but only after rising sharply earlier in the week.
France's 10-year government bond yield, as an example, was 2 bps lower at 0.86 percent, but only after having risen 8 bps from the start of the week.
Later on Friday, the United States is expected to release its December inflation data, which the market will use to form its rate hike forecasts.
Global bonds markets have been rattled this week by possible central bank action, starting on Tuesday when the Bank of Japan trimmed its purchase of long-dated Japanese government bonds.
(Reporting by Abhinav Ramnarayan & Fanny Potkin, Additional reporting by Saikat Chatterjee & Dhara Ranasinghe; Editing by Richard Balmforth and David Evans)