* Italy bond market recovery continues
* Broader euro zone bond yields up
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates pricing, adds German data)
By Dhara Ranasinghe
LONDON, Aug 7 (Reuters) - A recovery in Italy's bond market gathered pace on Tuesday, with yields edging lower and pulling further away from two-month highs hit at the end of last week as investors fretted about upcoming budget talks in Rome.
For some investors, the rise in Italian yields in the past week made the bond market there just too attractive to ignore, given sub-zero yields elsewhere in the euro zone.
Some positive signs from Italy's banking sector may also have boosted sentiment. The country's biggest bank UniCredit posted a better-than-forecast second quarter profit and said a widening in Italian government bond spreads, and the subsequent impact on its capital ratios, were under control.
Italian government bond yields were down 1-3 basis points across the board, in contrast to a slight rise in borrowing costs in broader euro zone bond markets.
Buy-backs of debt by the Italian Treasury in recent days have also helped to cap a rise in yields.
At one stage two-year Italian yields were down 6 bps at 0.91 percent before settling at 0.94 percent, still about 40 bps below a two-month peak touched on Friday at 1.36 percent.
"There is a great temptation on the part of real money accounts to go long Italian bonds because of the cheapening especially at the front-end of the curve," said Martin van Vliet, senior rates strategist at ING.
Still, analysts stressed that thin summer volumes were exaggerating price moves and added that Italian bonds remain vulnerable to the news flow.
The coalition government that took office in Rome in June has ambitious spending plans that have raised concerns on financial markets.
Senior government officials will meet on Wednesday to discuss next year's budget, Deputy Prime Minister Luigi Di Maio said on Tuesday. On Monday, he had said the government would apply European Union fiscal rules only if they did not impede its reform agenda.
Those uncertainties, plus simmering trade-war fears, have helped push yields on Germany's benchmark 10-year Bund yield down by 10 basis points from seven-week highs set last week.
Euro zone yields were higher on the day, after data showed the German economy is set for modest growth in the second quarter. Industrial output edged up and job vacancies hit a record high, underlining labour market strength that is fuelling a consumer-led upswing.
The 10-year Bund yield was last trading at 0.41 percent , up 2 bps on the day.
Focus was expected to turn to U.S. bond markets later in the day, with the U.S. Treasury begins its latest auction round with a $34 billion sale of three-year bonds.
Reporting by Dhara Ranasinghe Editing by Catherine Evans, Raissa Kasolowsky and David Stamp