JGBs edge down, but worries over economy limit fall

*Investors take a breather after month-long bond rally

*Lingering concerns over economy help limit losses

By Satomi Noguchi

TOKYO, July 16 (Reuters) - Japanese government bonds edged down on Wednesday, with the benchmark 10-year yield rebounding from a three-month low as investors took a breather after a month-long rally, but lingering concern about the economy limited losses.

JGB futures hovered near a two-month high, having climbed since mid-June as renewed credit jitters made investors doubt the chances of Federal Reserve interest rate hikes this year, which in turn reduced expectations for a Bank of Japan rate hike.

In testimony to U.S. Congress on Tuesday, Federal Reserve Chairman Ben Bernanke said restoring financial market stability was a top priority as a weakening housing market, tighter credit and soaring oil prices threaten the economy.

But Bernanke also said upside risks to the inflation outlook have intensified lately, which investors took as a signal that the Fed would keep interest rates unchanged at least through August and perhaps through the end of the year.[ID:nN15305285]

Analysts said Bernanke's inflation remarks left expectations intact that the Bank of Japan will hold rates steady for a while, thereby giving no new reason to add to bond holdings.

"The pessimistic view about the economy is already reflected in the market, with the 10-year yield falling near 1.5 percent," said Shinji Ebihara, an analyst in the fixed income group at Mizuho Securities.

"It is hard to push the yield down below 1.5 percent, given rising inflationary pressures, a factor we did not have in March when the market saw the yield falling close to 1.2 percent," Ebihara said.

September futures 2JGBv1 edged up 0.06 point to 136.49 but drifted in and out of negative territory near the two-month high of 136.79 hit on Tuesday, the highest since early May.

The benchmark 10-year yield JP10YTN=JBTC was up a basis point at 1.555 percent, but stayed close to a three-month low of 1.530 percent hit the previous day.

"The focus will be on whether the market will come to see a serious chance of a BOJ rate cut," said a senior trader at another Japanese Securities.

The five-year yield rose 1.5 basis points to 1.115 percent JP5YTN=JBTC, off a 2-½ month low of 1.075 percent struck on Tuesday.

The two-year yield edged down to 0.750 percent JP2YTN=JBTC, a lowest since May 13, holding just 25 basis points above the BOJ's policy rate.

BOJ Governor Masaaki Shirakawa said on Tuesday that the central bank is at a stage where it needs to carefully watch both downside risks to the economy and upside risks to prices, after leaving rates unchanged at 0.50 percent, as expected.

SAFE-HAVEN APPEAL

The Nikkei share average .N225 slipped 0.6 percent by midday after the Dow industrials closed below 11,000 for the first time in two years on Tuesday, keeping investors concerned about the impact of the weak U.S. economy.

U.S. banks shares .BKX fell to their lowest level since 1996 on Tuesday as investors feared the ongoing credit crisis could spur more bank failures after regulators took over IndyMac last week.[ID:nN15357673]

Shares fell even though U.S. Treasury Secretary Henry Paulson put together a rescue plan for the troubled mortgage finance giants, Fannie Mae (FNM.N) and Freddie Mac (FRE.N), in an effort to restore investor confidence.

Analysts said credit jitters increased the safe-haven appeal of bonds ahead of quarterly earnings from big U.S. investment banks later this week.[ID:nN15357673]

(Editing by Sophie Hardach)