(Updates for European close)

By Alun John

LONDON, Oct 8 (Reuters) - French bonds outperformed

their euro zone peers on Wednesday on the possibility that the

country's parliament may agree a budget by the end of the year,

despite the ongoing political crisis.

The mood was much calmer than earlier in the week when

developments in French and Japanese politics sent yields higher

worldwide, but with bond markets having been under pressure for

much of the year, the calm is unlikely to last.

French caretaker Prime Minister Sebastien Lecornu, who

tendered his resignation on Monday, struck a cautiously

optimistic tone earlier in the day, saying a deal could

potentially be reached on the country's budget by year-end,

making the possibility of a snap election less likely.

That sent the yield on France's 10-year bond to

its lowest since September 18 at 3.505%. It was last down 5

basis points on the day at 3.52%, having traded close to 3.6% on

Monday and Tuesday after the resignation of Lecornu, France's

fifth prime minister in less than two years. Bond yields move

inversely with prices.

GERMANY'S 10-YEAR YIELD DOWN 3 BPS

Germany's 10-year yield was down 3 bps at 2.679%

, narrowing the gap between French and German 10-year

yields to 84 bps down from nearly 88 bps on Monday.

The gap, the premium investors require to lend to France

rather than Germany, remains elevated and is among the highest

in the euro zone.

Analysts were wary of getting too excited about Wednesday's

move in French yields.

"I suspect there is some short covering going on, but it

doesn't really change the context," said Kenneth Broux, head of

corporate research FX and rates at Societe Generale, pointing to

France's large deficit.

"The risk premium in OATs (French government bonds) may be

here to stay for a while."

Lecornu was set to be interviewed on French TV about 8 p.m.

(1800 GMT), though the leader of France's Socialist Party

Olivier Faure said they could not back the government's budget

plan as it stands.

France aside, there was little else for euro zone bond

investors to process.

Data showed German industrial output fell much more than

expected in August due to a sharp decrease in production in the

car industry. But with the European Central Bank seemingly

firmly on hold for now, it would take a lot more bad economic

news to raise bets on a further rate cut this year.

Germany's rate-sensitive two-year yield dipped 1.5 basis

points to 1.987%.

Earlier, Japanese government bonds were also calmer

following a tumultuous few days as speculation swirled about the

course of the country's fiscal policy.

Still to come on Wednesday is the release of minutes of the

latest meeting of the U.S. Federal Reserve's rate setting

committee. It would not typically be market moving, though due

to the U.S. shutdown causing an absence of major economic data,

the minutes could take on greater significance.