UPDATE 2-Japan business pessimism spreads - Reuters Tankan

(For more stories on Japan's economy click [ID:nECONJP]) (Adds details)

By Shigeo Kodama

TOKYO, June 19 (Reuters) - Confidence among Japanese manufacturers remained stuck at a five-year low in June and non-manufacturers turned pessimistic, a Reuters survey showed, signalling that gloom was spreading across the economy.

Sentiment in the service sector turned negative for the first time in more than four years, the Reuters Tankan showed on Thursday, reflecting weak domestic demand and suggesting a poor result in the Bank of Japan's closely watched tankan corporate sentiment survey due next month.

"Confidence is low among both manufacturers and non-manufacturers, so it shows the economy is declining more widely," said Yoshikiyo Shimamine, chief economist at Dai-ichi Life Research Institute.

"I think the BOJ's tankan will also produce pretty bad numbers. It will show that the economy is definitely entering a downturn."

The Reuters Tankan, a monthly survey of leading Japanese firms that tracks the BOJ's quarterly tankan, found that Japanese companies expect their business conditions to improve slightly in the coming three months, however.

The survey produced an index of minus 2 for manufacturers in June, unchanged from the five-year low marked in May. [ID:nT77785]

For a graphic of the data click: here

In the survey, conducted from May 27 to June 16, the index for non-manufacturers' sentiment fell 2 points from May to minus 2, the lowest since minus 11 marked in December 2003.

Compared with three months ago, the index was down 10 points for manufacturers and 4 points for non-manufacturers.

The weak readings mean the BOJ tankan due out on July 1 will likely show a worsening of business sentiment from three months before, heightening views that the central bank will keep interest rates on hold at 0.5 percent this year.

Swap contracts on the overnight call rate show investors now see slightly less than a 50 percent chance of a rate hike to 0.75 percent by year-end JPONIBOJ=TRDT. Last week, markets were fully pricing in a rate rise this year.

The Reuters Tankan index is derived by subtracting the percentage of respondents who say business conditions are poor from that who say they are good. A result below zero means more of those surveyed are pessimistic about conditions.

RETAILERS DOWNBEAT

Japan's economy has logged firm growth in the last two quarters but analysts warn of a downturn this year on concern that deepening U.S. economic troubles will spread.

Economists polled by Reuters say Japan's economy will contract slightly in the April-June quarter and slow more in the fiscal year to next March than was expected a month ago, even as inflation climbs. [ID:nL12354252]

The outlook index over the next three months stood at plus 4 for manufacturers and plus 1 for non-manufacturers.

Among the sectors driving down manufacturers' sentiment were steel and nonferrous metal makers, whose confidence in June was zero, flat from May but down from plus 17 in March, as higher costs of iron ore and other materials hurt revenues.

The index for metal products and machinery makers fell to a five-year low of minus 14 and that for precision equipment makers slid to a nearly three-year low of minus 18, with many complaining of lacklustre demand and sharp rises in energy costs.

"We're seeing falling demand as utilities trim investment and maintenance costs," one metal firm said. "Sales prices are not catching up with soaring material costs."

Retailers, which track trends in personal consumption, saw sentiment worsen 20 points from May to minus 15 in a sign that slow wage growth was keeping consumers' purse strings tight.

Signs of weakness in the corporate sector led the BOJ to downgrade its view on exports and corporate profits in a monthly report last week.

The BOJ has kept monetary policy on hold since hiking its key interest rate target to 0.5 percent in February last year. It abandoned its tightening bias in April to switch to a neutral stance due to heightening economic uncertainty.

While some in markets are betting on a rate rise later this year, many economists expect the central bank to keep rates steady at least until early next year.

"The BOJ is taking a neutral stance on monetary policy for now but I think it is focusing somewhat more on downside economic risks," said Yasuo Yamamoto, a senior economist at Mizuho Research Institute.

"It's quite unlikely the bank will raise interest rates." (Additional reporting by Leika Kihara and Mari Saito; Editing by Michael Watson)