JGBs up on Nikkei, capped before 10-year auction

* JGBs rebound from Tuesday's slide as Nikkei drops

* Bonds' upside capped before 10-year auction

* ECB meeting, US jobless data eyed with caution

By Shinichi Saoshiro

TOKYO, July 2 (Reuters) - Japanese government bonds drifted higher on Wednesday, underpinned by a fall in Tokyo shares that offset U.S. data the previous day showing the manufacturing sector posted growth for the first time in five months. JGBs steadied from a sharp slide the previous day when the Bank of Japan's quarterly tankan survey showed sentiment at big manufacturers hit a five-year low but deteriorated less than expected.

Falling stock prices, which came despite overnight gains in Wall Street, set bonds on course for a rebound.

"The bonds reacted to the decline in the Nikkei, which fell beyond expectations," said Chotaro Morita, chief fixed-income strategist at Barclays Capital.

The Nikkei stock average .N225 was down 1 percent, dented by worries about the global economy and a stronger yen. It was on track for a tenth straight day of losses and its longest losing streak in over 40 years.

But the rebound in JGBs was stemmed in thin trading as market participants opted to stay on the sidelines ahead of potential market-moving events later this week.

The 10-year yield JP10YTN=JBTC dropped 1.5 basis points to 1.655 percent. It jumped 8.5 basis points on Tuesday in reaction to the tankan.

The benchmark 10-year yield fell to a seven-week low of 1.585 percent on Monday.

September 10-year futures 2JGBv1 rose 0.03 point to 134.72 following a 0.76 point plunge on Tuesday.

"The (benchmark) yield has already gone below 1.600 percent, and any decline towards that threshold is likely to be limited before the 10-year auction," said Morita at Barclays Capital.

Potential buyers of the new issue will begin losing interest the closer the 10-year yield gets to 1.600 percent, he added.

Bond dealers are bracing for a 1.9 trillion yen ($17.92 billion) auction of 10-year paper on Thursday, with the coupon likely to be set at 1.7 percent based on current yield levels compared with a 1.8 percent coupon in the previous month's auction.

The upcoming U.S. non-farm payrolls data and the European Central Bank meeting, both slated for Thursday, also added to the wait-and-see mood in the JGB market.