JGB futures drop as market anomalies stir worries

* Futures slip from 4-month peak on profit-taking

* Players eye reversal in futures surge relative to cash JGBs

* Steep futures cause market anomalies, stir worries

* Key resistance for 10-year bond yields seen at 1.4 pct

By Rika Otsuka

TOKYO, Aug 27 (Reuters) - Japanese government bond futures retreated from a four-month high on Wednesday, as investors booked profits after a steep rally in the past month and on views that the Bank of Japan is unlikely to cut interest rates.

JGBs have climbed on mounting signs the U.S. downturn is taking a toll on Japan and the global economy -- concerns behind the BOJ's decision to leave interest rates on hold at the current 0.5 percent level.

But investors have come to feel that more signs of economic or financial sector distress are needed before chasing JGB yields any lower, especially as the hefty gains in futures have caused anomalies in other parts of the JGB market.

"Investors have already been finding it difficult to push short- and mid-term yields lower for some time because the BOJ is not seen as lowering rates," said Akihiko Yokoyama, chief JGB strategist at JPMorgan Securities. "Yields have stopped falling across the curve now."

Seven-year JGB yields, which have the closest correlation with futures, matched five-year yields at one point in what market players said was a signal that the futures-led rally may have gone too far.

Futures are likely to outperform cash bonds as long as credit market jitters persist, said Yokoyama.

But analysts and traders warned that the unusual market moves meant futures and seven-year bonds were at risk of a sell-off.

"Futures look extremely expensive now," said a senior trader at a Japanese brokerage.

Stefan Liiceanu, a senior fixed-income strategist at Barclays Capital, said futures being so high compared with the cash market was "very, very strange".

Liiceanu said the likely outcome was either that trend-following speculators such as commodity trading advisers or CTA funds would be forced to sell futures, or relative-value funds betting on a reversal of the trend would be forced to buy futures.

September 10-year futures dropped 0.41 point to 138.08 2JGBv1. During Tuesday's after-hours trade, the lead futures contract rose as high as 138.80 1JGBv1, its highest since April.

Futures have driven the bond market's gains as some market players rushed to cover short positions and after a 20-year debt auction met with strong demand from institutional investors.

September futures have soared more than 3 points in the past month.

Those gains have led to other anomalies in the market, like seven-year inflation-linked JGBs pricing in negative inflation rates because of the futures-driven surge and its impact on regular JGBs.

The five-year yield rose 3 basis points to 1.005 percent JP5YTN=JBTC, while the seven-year yield based on older 10-year bonds JP02760067=BBRQ was at 1.010 percent.

The benchmark 10-year yield edged up 2.5 basis points to 1.440 percent JP10YTN=JBTC, up from a four-month low of 1.405 percent touched on Monday.

The 1.4 percent level has proven to be strong psychological resistance, with analysts saying the yield would likely stay above that level in the short term as investors await details of the government's steps to support the economy.

The government is expected to outline an economic relief package soon, with any extra bond issuance to fund the spending seen as a potential negative for the market.

The two-year yield, the most sensitive to the central bank's monetary policy outlook, inched up 2 basis points to 0.710 percent JP2YTN=JBTC.

Despite more signs that the slower global economy is taking its toll on Japan, a BOJ rate cut is seen as very unlikely because policy rates are already so low. Money market futures are showing little chance of either a rate hike or cut.

BOJ Governor Masaaki Shirakawa said on Monday that central banks should be careful about the negative effects of keeping rates too low. He also downplayed the risk of a lengthy economic contraction. [ID:nT367953] (Additional reporting by Eric Burroughs; Editing by Edwina Gibbs)