September 22, 2017 / 7:32 AM / a year ago

German bond yields steady below 7-week highs as election test looms

* 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

By Dhara Ranasinghe

LONDON, Sept 22 (Reuters) - German bond yields steadied just below 0.5 percent on Friday, ahead of German elections this weekend that are expected to return Angela Merkel as leader of Europe’s biggest economy.

Compared with the run-up to French elections earlier this year, Sunday’s upcoming vote in Germany has gone largely unnoticed on the market’s radar.

Merkel has been German 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.

Commerzbank analyst Michael Leister said investors would probably use Friday’s trading session to “fine-tune” positioning ahead of the election, while expectations of another coalition government between major parties could tighten German bond yield spreads against lower-rated southern European peers.

“The overall expectation is that we will get a Grand Coalition,” he 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.”

In early Friday trade, Germany’s 10-year government bond yield was steady at 0.45 percent, down from a 7-week high hit on Thursday at 0.50 percent in the wake of this week’s hawkish statement from the U.S. Federal Reserve.

One source of potential market anxiety heading into Sunday’s vote is the performance of the far-right Alternative for Germany (AfD), which has gained popularity by focusing on migration and security.

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. A GMS poll and one other also 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 largely flat on Friday, although Portuguese yields were set for their biggest weekly fall since February 2015.

Portuguese bond yields have tumbled 35 basis points this week following the country’s return to an investment grade rating with major ratings agency Standard & Poor’s.

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

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