LONDON (Reuters) -German conservative leader Friedrich Merz failed to garner the parliamentary majority needed to become chancellor on Tuesday in an unexpected setback for his new coalition with the centre-left Social Democrats.

German blue chip shares extended their fall on the news and was last down nearly 2%, while the broader European share index was down around 0.85%.

Domestic focused midcaps fell nearly 3%.

The euro gave back early gains on the dollar to last trade flat at $1.1230, and was down 0.34% on the safe-haven Japanese yen at 162.1. German bonds saw muted reactions with the 10-year yield last up 2 bps on the day at 2.54%.

COMMENTS:

DAVID ZAHN, HEAD OF EUROPEAN FIXED INCOME, FRANKLIN TEMPLETON, LONDON:

"I'm not overly concerned. There are different political parties and people playing for position (in terms) of what they can demand in order to give support. He (Merz) has this coalition, it's an okay coalition, it's not incredibly strong, and so therefore he will be susceptible to things like this. I expect that they'll have another vote or two, and then it will be fine."

"If we went to a third or fourth vote and he still couldn't get it, then we have different issue. I don't think this changes overall economic policy. He has a very aggressive economic policy, which is going to make to try to make the economy grow faster, make Germany more central on the global stage, which for German growth is fantastic."

RICHARD MCGUIRE, HEAD OF RATES STRATEGY, RABOBANK, LONDON:

"The Rubicon has been crossed. Germany has the ability to spend beyond the previous confines or limitations of the constitutional debt break."

"Who's leading the country determines its willingness to do that... but judging by the market's reaction, it seems that perhaps Merz's having failed the first vote is seen as a temporary stumbling block rather than heralding a possible change in political direction."

CARSTEN BRZESKI, GLOBAL HEAD OF MACRO RESEARCH, ING, FRANKFURT:

"Well, it (stock markets) reacted but with a delay, showing investors exactly what it is: namely that the government still needs to convince its own supporters that it will be able to deliver. The failed vote is clearly a sign that not everyone in the CDU (Christian Democratic Union) agrees with the fiscal U-turn."

HOLGER SCHMIEDING, CHIEF ECONOMIST, BERENBERG, LONDON:

"This is a significant negative. He (Merz) is still likely to get elected but this shows that the coalition is not united, which could weaken his ability to pursue policies."

STEFAN KOOPMAN, SENIOR MARKET ECONOMIST RABOBANK, AMSTERDAM:

"The market still sees Merz eventually becoming Chancellor. While (this is) a bit of an embarrassment, he fell only six votes short this time, and under Germany's constitutional playbook, a Chancellor candidate who fails to secure an absolute majority in three rounds can still squeak through on a relative majority in the fourth."

"But it's not a good sign as he already suffers from low approval ratings among voters and the AfD looks to be strengthening."