* Merkel says efforts to form three-way coalition fail
* Risk of new German election rises
* Bund yield slips to 1-1/2 week low
* But moves limited as euro, stocks bounces back
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices)
By Dhara Ranasinghe
LONDON, Nov 20 (Reuters) - German bond yields steadied near 1 1/2-week lows on Monday after talks to form a coalition government failed.
Yields struggled to push much lower as investors brushed off initial concerns about rising political risk in Europe’s biggest economy.
European shares recovered from early selling as confidence about the outlook for the euro zone economy helped investors ignore worries about the risk of new elections in Germany.
That in turn limited demand for safe-haven bonds - an early rally in German debt ran out of steam as the session wore on.
“The reaction in markets has not been dramatic,” said Antoine Bouvet, rates strategist at Mizuho. “At the end of the day, it’s not that easy to call for another election in Germany and there is still the potential outcome for a minority government.”
Late on Sunday, the pro-business Free Democrats (FDP) unexpectedly pulled out after more than four weeks of negotiations with German Chancellor Angela Merkel’s conservative bloc and the ecologist Greens, citing irreconcilable differences .
Germany now faces two possible options unprecedented in the post-World War Two era: Merkel forms a minority government, or the president calls a new election if no government is formed.
“The collapse of the talks was a surprise and there is little clarity on how things will unfold from here,” said Rainer Guntermann, rates strategist at Commerzbank.
Merkel said on Monday she would stay on as acting chancellor and consult President Frank-Walter Steinmeier on how to proceed.
Steinmeier said all parties have a responsibility to try and form a government in the near future.
The yield on Germany’s benchmark 10-year government bond, perceived as one of the safest assets in the world, initially dipped around 1.5 basis points to around 0.35 percent , its lowest level since Nov. 9.
But it then pulled back to 0.36 percent as the euro and stock markets recovered. Other high-grade euro zone bonds yields were also flat to a slightly lower on the day. Lower-rated Southern European bonds outperformed, dropping 3 to 4 bps.
The euro recovered from a two-month low against the yen hit in Asian trade, with investors brushing off the broader political risks in Germany.
Germany’s blue-chip stock index reversed early falls, pushing into positive territory in line with regional peers.
Merkel was damaged by the Sept. 24 election, in which people upset over her decision in 2015 to open German borders to more than a million asylum seekers punished her conservatives by voting for the far-right Alternative for Germany party.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets
Reporting by Dhara Ranasinghe; Editing by Larry King