By Marc Jones
LONDON (Reuters) - Investors' confidence that Chancellor Angela Merkel will win German elections on Sunday and press on with strengthening the euro zone is overriding their doubts about the makeup of her next government.
Markets in some of Europe's weakest economies should benefit most from Merkel's likely re-election for a third term, as she may then be ready to make compromises that are unpopular with her voters but needed for tackling the bloc's pressing problems.
Opinion polls suggest Merkel's conservatives will win easily on Sunday but which party will join them in her next coalition remains uncertain, although investors will be most unsettled if a new eurosceptic party gains a foothold in parliament.
Germans are electing the Bundestag lower house for the first time since the euro zone debt crisis erupted in 2010, and any major protest vote could punch a hole in market confidence that Berlin will do whatever is necessary to keep the euro together.
Germany's economy is picking up, its DAX stock index is at a record high and the euro has recovered from the doubts over its very future just over a year ago.
Merkel's Christian Democrats and their Bavarian sister party would prefer four more years in coalition with the business-friendly Free Democrats (FDP).
However, recent polls show her junior partner only just above the five percent threshold for staying in parliament. Should the FDP stumble, Merkel may be forced back into a "grand coalition" with the Social Democrats (SPD), like her first government of 2005-2009.
Coalition talks with the Social Democrats, with whom the conservatives have greater ideological differences, could take weeks, said William De Vijlder, Chief Investment Officer at BNP Paribas, although markets would be hurt only modestly.
Such uncertainty would affect weaker economies on the euro zone's "periphery", pushing up yields on the likes of Spanish and Italian debt relative to Germany's, the euro zone benchmark.
"If it drags on we would have some marginal weakening of the euro and a marginal widening of spreads in the periphery," said De Vijlder. "But these are probably only short-term issues because the (political) agenda is already set," he added, noting Germany's desire to push on and strengthen the euro zone.
Markets will be relieved just to have Germany emerge from months of political vacuum when many of the euro zone's problems have been put on hold as Merkel avoided endorsing any steps that would go down badly with her voters before the election.
Issues that have been put on hold include a third bailout for Greece - whose collapse in 2010 opened the euro zone crisis - and more aid for Portugal. Most urgent of all is the need for banking union, which aims to restore confidence in the financial system after a series of taxpayer-funded bailouts.
Germany, the biggest contributor to the bailouts, fears it will also become liable for problems at other countries' banks. However, euro zone officials say Berlin is now considering a plan that could reinvigorate the project, albeit on a less ambitious scale.
Salman Ahmed, global fixed income strategist at Lombard Odier, said there has been an unusual lack of market tensions in the run up to the elections. Volatility in the euro-dollar exchange rate has been extremely low, while euro zone periphery bond markets have been largely calm.
PRESSURE ON EURO
So far the Social Democrats and their Green allies have supported Merkel in parliament on all euro zone crisis votes, clearing the way for bailouts for Greece, Portugal and Ireland.
In coalition negotiations, the SPD would probably push for more measures to boost economic growth and for faster, deeper European integration than a coalition of the conservatives and the FDP would want.
Uwe Zöllner, head of European Equities at Franklin Templeton Investments, said stocks in the euro zone's high-debt nations which are expected to need future support from Germany could react most to Sunday's result.
"The DAX should not be the index most impacted by this. I think the indices in Italy and Spain are actually more exposed to it to discount the future politics of Germany towards the euro," he said.
WHAT DO THE POLLS SAY?
A likely market-moving scenario sees the Alternative for Germany (AfD), which was launched in February and has made rapid gains by arguing for an "orderly dismantling" of the euro, clearing the 5 percent hurdle for entering the Bundestag.
The fact that the European Central Bank is standing by its promise to buy the bonds of struggling nations if needed would prevent any major moves. However, this outcome would hit European equities and weigh on the euro and government bonds of Greece, Portugal, Italy, Spain and Ireland.
Ian Stannard at Morgan Stanley said markets were simply not positioned for anything other than a continuation of the current "keep the euro together" policy. There could also be a lag before the market impact of the election result becomes clear.
Even if the current coalition survives, "once Greece comes back on the agenda later in the year we will see how much support she (Merkel) really has", Stannard said. "If she starts to struggle to gain the necessary support I think that will put pressure back on euro."
Polls already reflect impatience among German taxpayers with the cost of the bailouts, but Merkel has contained this, partly by insisting on tough austerity for the recipient states.
Germany's Constitutional Court has also calmed concerns by insisting the Bundestag is fully consulted on future bailouts, although its ruling in the next few weeks on whether the ECB's yet-to-be tested bond buying program is legal is hanging over markets.
The least likely election outcome is the SPD and Greens overcoming their historic aversion to the hardline Left party to form a coalition that sidelines Merkel. SPD challenger Peer Steinbrueck categorically rules it out, as do the Greens.
Gavin Friend, an FX strategist at National Australia Bank in London, said a "government of disparates where Merkel doesn't get in" would be a worst-case scenario and could see the euro drop to $1.33 from its current perch of $1.35.
One equity analyst at a major euro zone bank said the DAX could lose 500 points within a fortnight if Merkel failed to get back in - or if there were a strong showing from the AfD.
"A critical voice would accompany any future decisions on the euro and the fact it will be a voice in the parliament would weigh on sentiment," the analyst said on condition of anonymity.
(Additional reporting by Stephen Brown; editing by David Stamp)