We need a merchant in the battledepths for between dungeons...

As it say;

we need a merchant in the battledepths to accomidate you between the second last and last dungeons. Otherwise you enter the last dungeon with a full storage and you dont want to be dealing with that during battle.

That might be true to most of the dungeons. I have found myself with full inventory trying to recycle some of the drops or just plain left them there.

Same here. I find my inventory half way full a lot of times before I even reach certain dungeons

There is a dwarven merchant in Varajar Fells, next to the portal for the Battledepths.