JGBs drop after US, euro zone bonds slide on ECB

By Masayuki Kitano

TOKYO, June 6 (Reuters) - Japanese government bonds fell sharply on Friday, a day after the European Central Bank shocked markets by saying it may raise interest rates as soon as July, hitting U.S. Treasuries and euro zone bonds. After a recent sell-off pushed 10-year yields to a 10-month high, JGBs had gained some reprieve this week on worries about credit-market related losses at major financial institutions and domestic investor buying of cash bonds.

But the positive mood was erased after European Central Bank chief Jean-Claude Trichet said on Thursday interest rates may go up next month.

"Trichet spoiled all of that," said Kazuhiko Sano, chief fixed income strategist for Nikko Citigroup in Tokyo.

JGBs were also dragged lower as Tokyo's Nikkei share average climbed 1.7 percent in early trade .N225.

Although signs of a slowdown in the Japanese economy support the bond market, the sell-off in JGBs could gather steam in the near term, Sano said, adding that 10-year yields could rise to 2.0 percent or higher in the next month.

June 10-year JGB futures fell by as much as 1.08 point to 134.15 2JGBv1, just three days after they matched their biggest one-day rise in five years.

June futures later trimmed some losses to stand at 134.49 for a decline of 0.74 point, edging back towards a 10-month low of 133.54 struck on Monday. Trading volume was moderate, at around 12,000 contracts.

The benchmark 10-year JGB yield rose 4.5 basis points to 1.770 percent JP10YTN=JBTC, nearing a 10-month high of 1.805 percent hit last week.

Selling also spilled over into the money market, with the lead three-month euroyen futures contract dropping by as much as 10.5 basis points to 98.855 JEYv1.

ECB President Jean-Claude Trichet on Thursday dropped a clear hint that rates could go up next month, saying that a quarter of a percentage point rise was "possible" although not "certain".

He said the Governing Council had agreed to leave rates on hold at 4 percent for this month but was determined not to fall behind the curve on tackling inflation. [ID:nL05372262]

Trichet's comments caused the yield on two-year euro zone government bonds to soar more than 30 basis points to its highest this decade and knocked U.S. Treasuries lower on Thursday. [nL05224457] [US/]

(Editing by Sophie Hardach)