By John Geddie
LONDON (Reuters) - The euro and European government bond yields slipped on Monday after the bloc's most powerful leader, German Chancellor Angela Merkel, won a fourth term but faced a fractured parliament as support for the far right surged.
Investors were unnerved by the prospect of months of coalition talks that could distract from negotiations with Britain over its divorce from the European Union and efforts to integrate the bloc's remaining members.
Some analysts said the political uncertainty may also throw into question European Central Bank plans to reduce monetary stimulus, a move likely to be announced at the ECB's next meeting on Oct. 26.
"There might be some concerns at the ECB that a less stable and less pro-EU German government will have negative implications for the (economic) outlook. That would be dovish," said Frederik Ducrozet, an economist at Pictet Wealth Management.
Business confidence in Germany deteriorated unexpectedly in September, a survey on Monday showed, and the chief economist of the Ifo economic institute said the election result could stoke further uncertainty.
A decline in the euro accelerated after the data, and by 1040 GMT it was down 0.6 percent at $1.1885 . That put more distance between a 2-1/2-year high of $1.2092 reached on Sept. 8, when the last ECB meeting fuelled expectations the central bank would begin tapering its massive stimulus programme.
Europe's benchmark German bond yield was set for its biggest daily fall in seven weeks, down 5 basis points at 0.40 percent .
The fall was less pronounced in Southern European bond yields as the election result led to concerns about the emergence of a more hardline stance towards the euro zone in the bloc's largest economy.
While Merkel held on to power in Sunday's vote, the surprise winners were the anti-immigration Alternative for Germany (AfD), which became the first far-right party to enter the country's parliament in more than half a century.
All parties have ruled out a coalition with the AfD but investors are unsettled by the possibility Merkel may have to form a coalition with the Free Democrats (FDP), who are seen more opposed to deeper financial integration in the euro area and might take a more hardline stance on Greece's debt.
"This suggests headwinds to the euro and periphery," analysts at Morgan Stanley said in a note.
The impact on stock markets from the election was less marked, with euro zone shares down around 0.2 percent <.STOXXE>.
That followed sharp falls in Asian equities which were hit by concerns over the economic health of the world's second biggest economy China, while Wall Street was set to open a touch lower .
MSCI's broadest index of Asia-Pacific shares outside Japan <.MIAPJ0000PUS> was down 0.8 percent.
Hong Kong's Hang Seng <.HSI> was down 1.3 percent and Shanghai <.SSEC> slipped 0.4 percent after a number of Chinese cities rolled out new measures to cool housing prices.
Asian investor sentiment was also undermined by concerns that China's beefed-up environmental protection could reduce demand, and consequently economic growth.
The New Zealand dollar was also hit by political jitters as the ruling National Party won the largest number votes in a weekend election but failed to secure a ruling majority, with a protracted period of coalition-building now also a possibility there.
The kiwi, the world 11th most-traded currency, was down 0.7 percent at $0.7288 and set for its biggest daily drop in around a month.
It was at a 1-1/2-month high of $0.7435 as recently as Sept. 20, when speculation for a comfortable win by the ruling party had boosted the currency.
"While there are a few different scenarios and some potentially testy issues to negotiate, ultimately the political landscape appears as though it will remain relatively centralist and we are reasonably agnostic on what it all means," wrote economists at ANZ.
The pound edged up 0.1 percent to $1.3510, bouncing back from a slide on Friday when ratings agency Moody's downgraded Britain's credit rating.
The dollar was up 0.3 percent against a basket of six major currencies at 92.397 <.DXY>.
Oil prices rose to their highest in seven months after major producers said at a meeting in Vienna the global market was well on its way towards rebalancing. [O/R]
The November Brent crude futures contract was up 35 cents at $57.21 a barrel, its highest since Feb. 23, while U.S. crude for November delivery was down 8 cents at $50.58, but not far off recent four-month highs.
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
(Additional reporting by Shinichi Saoshiro in Tokyo; Editing by Toby Chopra and John Stonestreet)