September 22, 2017 / 10:38 AM / in a year

UPDATE 2-German bond yields steady below 7-week highs as election test nears

* German national elections take place Sunday

* Fourth term expected for Chancellor Angela Merkel

* Performance of far-right AfD in focus

* Bund yields hold below 0.5 pct ahead of vote (Adds UK PM May’s speech, updates prices)

By Dhara Ranasinghe

LONDON, Sept 22 (Reuters) - German 10-year bond yields steadied around the 0.45 percent mark on Friday, ahead of national elections this weekend that are set to return Angela Merkel to office as head of Europe’s biggest economy.

Compared with France’s elections earlier this year, Sunday’s vote in Germany has passed largely unremarked on by the market.

Merkel has been chancellor since 2005 and her re-election is seen bring continuity and stability, although there is uncertainty about the composition of a likely coalition and some concern about the strength of the far right.

Merkel’s conservative alliance currently governs in a ‘grand coalition’ with the centre-left Social Democratic Party.

“The overall expectation is that we will get (another) grand coalition,” Commerzbank analyst Michael Leister said. “In a scenario that doesn’t include the liberal FDP becoming part of the government, we could also see speculation about further European integration tighten.”

On Friday, Germany’s 10-year government bond yield was flat at 0.45 percent, down from a seven-week high hit on Thursday.

One source of potential market anxiety is the performance of the far-right Alternative for Germany (AfD) in Sunday’s vote.

With many voters viewing a fourth term for Merkel as almost inevitable, pollsters say turnout may be low.

The AfD has been running at between nine and 12 percent in surveys. Two polls published on Thursday showed it chalking up gains that look set to make it the third largest bloc in parliament.

“A strong performance from AfD and other populist parties would reflect a protest vote from people unhappy with the direction things are going in Germany,” said David Zahn, head of European fixed income at Franklin Templeton Investments.

“And that, in turn, should serve as a signal to mainstream parties that they need to make adjustment to the economy. Otherwise, the chances are greater that more extremist parties could get a larger vote next time.”

Most euro zone bond yields were a touch higher on Friday, facing some upward pressure after upbeat economic data.

Euro zone bonds were unmoved after UK Prime Minister Theresa May called on Friday for Britain to stay in the European Union’s single market during a roughly two-year transition out of the EU while offering concessions on a divorce deal as she appealed for a revival of Brexit negotiations.

IHS Markit’s euro zone Flash Composite Purchasing Managers’ Index for September, seen as a good guide to economic growth, bounced to 56.7 from August’s 55.7.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=

Reporting by Dhara Ranasinghe; Editing by Keith Weir and John Stonestreet

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