* Pro-spending, pro-Europe SPD set to control German purse strings
* Coalition news positive for European integration
* Italian, Spanish and Portuguese yields drop
* Outperformance over better-rated peers extends (Writes through, adds graphic)
LONDON, Feb 7 (Reuters) - Southern European government bond yields dropped on Wednesday and extended a recent outperformance over peers on reports that Germany's pro-European, pro-spending Social Democrat (SPD) party would head the finance ministry in a coalition government.
German Chancellor Angela Merkel's conservatives and the SPD agreed "in principle" on Wednesday on a coalition deal, sources involved in the talks said, taking Europe's economic powerhouse a step closer to a new government.
In addition, reports suggested the SPD would take the finance ministry in addition to the foreign and labour ministries, which would give the party control over the purse strings of Europe's largest economy.
Olaf Scholz, a Social Democrat (SPD) who is mayor of Hamburg, is set to become German Finance Minister in a new coalition government with Chancellor Angela Merkel's conservatives, German news agency DPA reported on Wednesday.
"This news is positive for spreads and for anyone that wants a well-constructed and viable Europe. Investors in the higheryielding sovereigns in the euro area want that to happen so that we don't go through another crisis," said Peter Chatwell, head of rates strategy at Mizuho.
"So having a distinctly European flavour to a German grand coalition is very helpful in that respect."
In addition, the SPD tends to favour spending over austerity, suggesting there will be a move away from the firm fiscal policies championed by former conservative Finance Minister Wolfgang Schaeuble.
Italian, Spanish and Portuguese 10-year government bond yields were 5-7 basis points lower on the day, and spreads over benchmark German Bunds tightened.
This extends a strong outperformance of Southern European government debt in recent weeks as a booming economy and ratings upgrades for all three countries give investors confidence to pick up the extra yield on offer.
For example, Italy's 10-year government bond yield spread over Germany is now close to its tightest level since September 2016 at around 123 basis points.
Spain and Portugal recently were at their tightest yield-spread levels against Germany in nearly eight years.
Other euro zone bond yields were also broadly lower on the day, falling 1-2 basis points.
Comments from ECB officials had little immediate market impact although there was some focus on U.S. policymakers scheduled to speak later in the session.
The U.S. Federal Reserve's Robert Kaplan, William Dudley and Charles Evans are all due to speak later in the day.
"We may see some comments from officials today on the market volatility. Investors will be watching for how they will treat this - I would be surprised if they take it too lightly," said ING strategist Benjamin Schroeder.
A rout in world stock markets this week has helped support safe-haven bonds.
(Reporting by Abhinav Ramnarayan and Dhara Ranasinghe; Editing by Mark Heinrich, William Maclean)