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UPDATE 2-Budget debate, election talk take shine off Spanish bonds

* Spanish 10-year bond yields edge away from 10-month lows

Budget vote due Wednesday, election talk ramps up

* German Bund yields hold above 2-year lows

* Euro zone periphery bond yields http://tmsnrt.rs/2ii2Bqr (Updates pricing, adds quote)

By Dhara Ranasinghe

LONDON, Feb 12 (Reuters) - Spain's 10-year bond yield dipped on Tuesday alongside southern European peers but held above recent 10-month lows in a sign of some caution among investors ahead of a budget vote this week and growing talk of a possible early election.

Outside the periphery, the bloc's 10-year bond yields edged up as a deal to avert a U.S. government shutdown lifted stocks and dented demand for fixed income.

The spotlight fell on Spain, where Prime Minister Pedro Sanchez was reported on Monday to be considering a snap election for mid-April, as the government scrambles to find support to get its 2019 budget through parliament.

Sanchez's party depends on the vote of smaller parties, including Catalan nationalists, who have said they will vote against the budget. It is expected to be debated on Tuesday, followed by a vote on Wednesday.

To complicate matters, 12 Catalan secessionist leaders went on trial at Spain's Supreme Court on Tuesday over their role in a failed 2017 independence bid.

"Passing the budget won't be easy and there is a risk of early elections, so recent developments in Spain have been a bit of a wake-up call for markets," said Michael Leister, rates strategist at Commerzbank.

"Also keep in mind that SGBs (Spanish government bonds) have performed well over the past week so the political noise is not helping."

Spain's 10-year bond yield fell to a low of 1.225 percent , but held above 10-month lows hit earlier this month at 1.19 percent. In contrast, Italian 10-year bond yields were down five bps and Portuguese yields fell two bps.

The difference between Spanish and Italian 10-year bond yields has narrowed to around 158 bps, having hit 178 bps last week -- the widest in more than two months -- on concerns about Italy's economic outlook.

Analysts said the relative strength of the Spanish economy meant that any fallout from election risks should be limited.

Roberto Coronado, a portfolio manager at PineBridge Investments, said he didn't think the Spanish government would call another election, as it was unlikely to win.

"Spain is in a different position to Italy in the sense that the political parties that could win an election in Spain are more neutral for markets," he said.

Pictet Wealth Management economist Nadia Gharbi noted a big divergence in growth forecasts for Spain and Italy. She expects Spain to grow 2.1 percent in 2019 and Italy just 0.3 percent.

Italy's economy slipped into recession late last year and data suggests the outlook remains weak.

While Italian bonds benefited from a rally in risk assets, Germany's 10-year Bund yield edged away from more than two-year lows hit on Friday, hitting a day's high of 0.146 percent.

The Netherlands meanwhile sold 5.88 billion euros of new 10-year bonds and its bond yields were 1.2 basis points higher at 1617 GMT,.

(Reporting by Dhara Ranasinghe, Editing by William Maclean, John Stonestreet and Peter Graff)