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LONDON, March 2 (Reuters) - Short-term German bonds could be pricing in a roughly 5 percent chance that government debt in the euro zone's biggest economy will be redenominated back into Deutsche marks over the next two years, according to research from Deutsche Bank.
The estimate, from fixed income strategists at Germany's biggest bank, highlights growing unease among investors about political risks facing the euro zone, including strong polling for anti-euro French presidential candidate Marine Le Pen.
Strategist Abhishek Singhania said the pricing is likely to reflect the importance of the behaviour of very conservative investors such as reserve managers and is not necessarily a reflection of the risk priced in by other financial markets.
His estimate that markets were pricing in a 3-6 percent chance of redenomination was based on two elements.
The first is an expectation that a German currency outside the euro zone would appreciate.
Based on an assumption that any redenomination of German debt would be into Deutsche marks, the currency used in Germany before the euro was created in 1999, Singhania said he used International Monetary Fund estimates that suggest the German exchange rate is undervalued by 10-20 percent.
The second is a widening between the yield on top-rated two-year German government paper and two-year Eonia money market swap rates since late last year.
The two normally reflect interest rate expectations and move in sync but, as this graphic reut.rs/2m2QxbW shows, have diverged in recent weeks as the bond yields have fallen sharply.
About 30 basis points of the widening gap between the two can be attributed to investors starting to position for redenomination risk, Singhania said.
European Central Bank buying, demand for high-quality debt to use as collateral and demand for a safe haven from heightened political risk in France have all been cited as factors behind a drop in two-year German bond yields to minus 0.96 percent in February.
"There is little upside to buy bonds at these levels but if you think there is the risk of an unexpected event such as redenomination then suddenly you can see why conservative investors might be willing to buy at extremely negative yield levels," said Singhania.
Paying a 0.6 percent premium over two years for a bond that would be worth 10-20 percent more in Deutsche marks shows the risk of redenomination is 3-6 percent.
Far-right candidate Le Pen, expected to go through to the final round of the French presidential election in May, although not to win, has vowed to take France out of the euro and redenominate the country's government debt in "new francs".
Eurosceptic movements in Italy and the Netherlands, which goes to the polls on March 15, have also gained prominence.
Singhania stressed that the pricing in of some redenomination risk in Germany did not imply markets expected Le Pen to win. But it does suggest conservative investors are more concerned about a euro zone break-up than during the bloc's prolonged debt crisis, which peaked in 2012. (Reporting by Dhara Ranasinghe; Graphic by Nigel Stephenson; Editing by Catherine Evans)