JGBs bounce as bargain hunters step in after Fed

* Bargain hunting emerges after Fed meeting passes as expected

* Curve steepens as superlongs sag on asset swap unwinding

* Two-year auction draws strong demand

By Shinichi Saoshiro

TOKYO, Jan 27 (Reuters) - Japanese government bonds pared earlier losses and gained on Thursday as investors picked up bargains, relieved a U.S. Federal Reserve policy meeting passed as expected.

The yield curve steepened as superlongs underperformed other maturities on the unwinding of asset swap positions, which involve buying a cash bond and paying in interest rate swaps of the same maturity.

"JGBs fell back early in a token reaction to weaker U.S. Treasuries. But underlying demand from bargain hunting was stronger in the longer run," said a trader at a European brokerage.

"Many investors had wanted to buy at these yield levels but had played it safe until the Fed meeting was out of the way."

The benchmark 10-year yield JP10YTN=JBTC was down 1 basis point at 1.220 percent after touching 1.245 percent. The yield had hovered near a one-month high of 1.260 percent marked last week.

The five-year yield JP5YTN=JBTC fell 1.5 basis points to 0.490 percent.

March 10-year futures 2JGBv1 gained 0.17 point to 139.78 with a bounce in Tokyo stocks curbing a further rise in the contract.

STRONG SALE

Thursday's 2.6 trillion yen ($31.6 billion) two-year JGB sale attracted strong demand, with the bid-to-cover ratio, a gauge of an auction's strength, rising to 5.33 from 3.50 at the previous offering in December. [ID:nMOFA15002]

"It was a good auction result, showing that there are no changes in the market's assumption towards the duration of the Bank of Japan's easy monetary policy," said Keiko Onogi, a senior JGB strategist at Daiwa Securities Capital Markets.

The BOJ revised up its consumer price forecast for fiscal 2011/12 earlier this week in the wake of rising commodity prices, but analysts said Japan's escape from deflation is still likely to be sluggish, preventing the central bank from raising rates for the duration of the new paper.

"The auction was also held at an attractive yield level for buyers. The situation remains the same, with financial institutions holding a lot of cash due to slack lending," Onogi said.

Japan's banks, flush with cash due to sluggish demand for loans and growing deposits, are the key buyers of short to midterm JGBs.

The 30-year yield JP30YTN=JBTC rose 1.5 basis points to 2.125 percent, widening the 10-year/30-year yield spread to 91 basis points from a three-week low of 88 basis points hit the previous day.

The Fed on Wednesday held interest rates steady and repeated that rates would remain exceptionally low for an extended period, offering only a very slight upgrade to its assessment of the U.S. economy. ($1=82.18 Yen) (Editing by Joseph Radford)