South Europe bonds lag as euro hardliners bound for German government

* "Peripheral" spreads widen after Merkel support drops

* Coalition could prove roadblock to euro integration

* German Bund yield set for biggest 1-day fall in almost 7 wks

* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates prices, adds Draghi, N.Koreas)

By Abhinav Ramnarayan

LONDON, Sept 25 (Reuters) - Southern European government bonds underperformed on Monday after an unexpectedly weak election result for Germany's Angela Merkel led to concerns about the emergence of a more hardline stance towards the euro zone in the bloc's largest economy.

Merkel secured a fourth term as chancellor but was weakened by a surge in support for the far right and investors were unsettled by the possibility that she may have to form a coalition with the pro-business Free Democrats (FDP) and Greens - the so-called "Jamaica" coalition.

Some also said the German result could complicate the European Central Bank's policy path as it looks to scale back its monetary stimulus programme, which has driven down borrowing costs since its launch in 2015.

"The pro-market Free Democrats, as well as part of the CDU/CSU, oppose deeper financial integration in the euro area," analysts at Morgan Stanley (Xetra: 885836 - news) said in a note. "This suggests headwinds to the euro and periphery."

The concerns come a day before French President Emmanuel Macron is due to announce his proposals for European Union reforms in a speech in Paris.

Lower-rated Spanish, Italian and Portuguese government bonds sold off and 10-year yields rose 3 basis points across the board in early trade.

They clawed back price losses as the session wore on, but remained underperformers on a day when higher-rated euro zone government bond yields fell 4-5 bps.

The Italy-Germany 10-year government bond yield spread hit its widest in 3 weeks at around 170 bps.

Germany's 10-year bond yield hit an 11-day low of 0.395 percent, down 6 bps on the day in late trade on renewed jitters over North Korea.

North Korea's foreign minister said on Monday that U.S. President Donald Trump had declared war on North Korea and that Pyongyang reserves the right to take counter-measures.

Yields on most other highly rated government bonds, such as those of Austria and the Netherlands, also fell.

Demand for those bonds comes at a time when investors are also wondering what the implications of the German election are for European Central Bank policy.

The ECB is largely expected to announce the end of its bond-buying scheme next month, as it seeks to unwind years of extraordinary post-crisis stimulus.

LESS STABLE

Pictet Wealth Management economist Frederik Ducrozet said the prospect of a less stable German government could lead to concerns about the euro zone economic outlook, potentially making the ECB more dovish.

Rabobank strategist Richard McGuire took a different view.

"On paper, the election should have no impact on the ECB, which is an independent body," he said. "But I think it's fair to say if you see a 'Jamaica' coalition, it would not be a constructive environment to continue to provide stimulus going into next year."

This may explain why investors are more willing to buy high-grade euro zone bonds than lower-rated Southern European ones, which are seen benefiting most from the ECB's largesse.

The safety-first approach was apparent in stock markets as well, with defensive health stocks and consumer staples outweighing weakness in riskier financials and miners.

The demand for these stocks – sometimes referred to as "bond proxies" because of their defensive nature – was enough to cancel out early losses on the pan-European STOXX 600 index, which was up 0.26 percent.

In particular, shares in German utility RWE (Amsterdam: RW6.AS - news) dropped more than 4 percent on the prospect of the anti-coal Greens being part of a German coalition.

The uncertainty also hit the single currency, which was down 0.8 percent at $1.1864.

"Markets don't like uncertainty and the German election results have injected a dose of uncertainty into markets," said Richard Falkenhall, a currency strategist at SEB AB in Stockholm.

"While it is still early to say what the outcome will have for the whole euro zone integration project, markets will be watching the political calendar more closely."

The result of the German election could stoke uncertainty among business as well, the chief economist of the Ifo economic institute said on Monday after business confidence deteriorated unexpectedly in September.

The ECB is growing increasingly confident that inflation will rise back to its target but patience is still needed, ECB chief Mario Draghi said on Monday.

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 Abhinav Ramnarayan, Additional reporting by Kit Rees and Saikat Chatterjee, Dhara Ranasinghe; Editing by Janet Lawrence and Pritha Sarkar)