UPDATE 3-Peripheral yields fall as SPD gets key German finance ministry in coalition deal

coalition deal@

* 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 (Updates with latest price action, quotes)

LONDON, Feb 7 (Reuters) - Southern European government bond yields tumbled on Wednesday, extending a recent outperformance over peers on reports that Germany's pro-European, pro-spending Social Democrat party would head the finance ministry in a coalition government.

German Chancellor Angela Merkel's conservatives and the centre-left SPD agreed to a coalition deal on Wednesday, taking it closer to a new government after months of political uncertainty.

Olaf Scholz, the SPD mayor of Hamburg, is set to become finance minister, the DPA news agency reported, giving it control over the purse strings of Europe's largest economy.

The SPD tends to favour spending over austerity, suggesting there could be a move away from the firm fiscal policies of former conservative Finance Minister Wolfgang Schaeuble.

"Do not underestimate the impact of the SPD getting the influential finance ministry," said Commerzbank's chief economist Jörg Krämer.

"This marks a huge change from the policy of Wolfgang Schäuble regarding European integration, transfer of risks towards the peripheral countries."

While German Bund yields jumped 4 basis points to 0.67 percent, peripheral debt yields tumbled 4-8 bps .

This took the gap between Italian and German 10-year bond yields to 119 bps, the tightest level since September 2016.

The Spanish/German yield spread was its narrowest in eight years at 65 bps, while Portugal's 10-year bond yields fell 7.5 bps to 1.99 percent and were set for their biggest one-day fall in five weeks.

The moves extended the strong outperformance of Southern European government debt in recent weeks, as booming economies and ratings upgrades for all three countries have given investors the confidence to pick up the extra yield on offer.

"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."

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.

Higher wages in the United States will not necessarily lead to faster inflation, Dallas Fed President Robert S. Kaplan said in Frankfurt on Wednesday.

The U.S. Federal Reserve's William Dudley and Charles Evans 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.

(Reporting by Abhinav Ramnarayan and Dhara Ranasinghe; additional reporting from Julien Ponthus; Editing by Jon Boyle)