Short-term JGBs climb, BOJ rate cut seen more likely

TOKYO Jan 23 (Reuters) - Short-term Japanese government bonds climbed on Wednesday and the two-year yield fell below the Bank of Japan's overnight rate target as expectations mounted for a rate cut this year to stem any damage from the U.S. downturn. JGBs pushed higher despite a 3 percent jump in Japanese shares as the Federal Reserve's unusually aggressive 75-basis point slash in overnight rates stirred some confidence among investors battered by the heavy sell-off in stocks.

But analysts said that bondholders were doubting whether equities would be able to sustain a recovery from the slide, which has driven the Nikkei share average .N225 down 15 percent in less than three weeks this year.

The Fed's hefty cut and acknowledgment of "appreciable" downside risks to the economy convinced investors other major central banks may need to loosen policy to limit the fallout on the global economy from a potential U.S. recession. BOJ Governor Fukui also stoked speculation of a rate cut by saying Japan's low rate of 0.5 percent would not constrain policy, even while sticking to his stance that the economy's long-term growth outlook was favourable.

The BOJ kept rates on hold as widely expected.

Naomi Hasegawa, senior fixed-income strategist at Mitsubishi UFJ Securities, said the market read to much in Fukui's remarks, but the possibility of a rate cut is real.

"It's certainly reasonable to start thinking about a rate cut later this year given the magnitude of the stock market declines," Hasegawa said.

The two-year yield, the most sensitive to changes in monetary policy, fell as low as 0.490 percent -- taking it below the BOJ's policy target for the first time.

Such a drop in short-term bond yields beneath a central bank's target usually precedes a policy shift.

At the end of the morning session, the two-year yield JP2YTN=JBTC was down 2.5 basis points at 0.500 percent.

March 10-year futures 2JGBv1 dipped 0.09 point to 138.73, holding off a 28-month high of 139.15 reached in the evening session on Tuesday.

The benchmark 10-year yield JP10YTN=JBTC edged up half a basis point to 1.320 percent after matching a 28-month low of 1.310 percent.

A Reuters poll on Tuesday after Fukui's press conference found a majority of market players believe the BOJ is more likely to raise rates than cut them, but a third said the next move could be a cut.

Thirty-six of 53 respondents in Tokyo's bond and currency markets said the BOJ's next move would be to raise rates, while 17 expected a cut. Any rate cut was seen coming before July, the poll showed. [BOJ/INT]

Swap contracts on the overnight call rate JPONIBOJ=TRDT were showing a 20 percent chance of a BOJ rate cut at its next meeting in February and a 50 percent chance of one in May, little changed from the previous day.

Analysts were revising down their forecasts for bonds yields in the coming year following the sell-off in stocks and worries about the Japanese economy.

Analysts at Nikko Citigroup cut their forecast for the 10-year JGB yield to 1.15 percent to 1.50 percent for the first quarter compared with 1.3 percent to 1.6 percent previously.

Nikki Citigroup says the two-year yield could fall as low as 0.40 percent on the rising rate cut expectations.

"It is nearly certain that the JGB yields will trade lower, especially in Q1, due to falling stocks and global market turmoil over the subprime mortgage problems," said Kazuhiko Sano, chief JGB strategist at Nikko Citigroup, in a note to clients.

(Additional reporting by Satomi Noguchi)