JGBs rise as Nikkei slips, yield curve steepens

By Masayuki Kitano

TOKYO, June 5 (Reuters) - Japanese government bonds rose on Thursday, supported by a dip in equities and demand for short- to medium-term bonds due to expectations that the Bank of Japan will keep interest rates steady for a while.

JGBs have gained some reprieve after a sell-off that pushed 10-year yields to a 10-month high last week, as worries about losses at major financial institutions lent support to a market roiled by concerns about inflation.

With the Bank of Japan still seeing downside risks to economic growth in the near term, JGBs were drawing some support as 10-year yields hovered near the 10-month high of 1.805 percent hit last week.

"Central bank chiefs of various countries have been talking about inflation. But with regard to Japan, we are not at a stage where market expectations about changes in short-term interest rates are likely to accelerate," said Chotaro Morita, chief fixed income strategist for Japan at Barclays Capital.

June 10-year JGB futures 2JGBv1 rose 0.36 point to 135.04 2JGBv1, pulling away from a 10-month low of 133.54 hit on Monday.

The benchmark 10-year JGB yield fell 1.5 basis point to 1.755 percent JP10YTN=JBTC.

JGBs drew some support from a 0.7 percent .N225 fall in the Nikkei share average, market players said.

The yield curve steepened, as short- and medium-term bonds outperformed.

The five-year yield fell 5 basis points to 1.270 percent JP5YTN=JBTC and the two-year yield slipped 4 basis points to 0.825 percent JP2YTN=JBTC.

There was some demand for short- and medium-term JGBs from investors, said a trader for a U.S. investment bank.

Overall, however, market players seem reluctant to allocate funds to bonds, said Atsushi Ito, fixed income strategist for Morgan Stanley.

"I don't think there are any moves to increase the overall level of risk-taking or to take on large positions," Ito said, adding that some investors may be switching between JGB issues, and perhaps dumping loss-making positions before entering into new ones.

INFLATION-INDEXED BONDS

Swap contracts on the overnight call rate show that investors widely expect the BOJ to raise interest rates by 25 basis points from the current 0.50 percent within the next year.

But the implied chance of a rate rise by September is seen at only 15 percent. JPONIBOJ=TRDT

Bank of Japan Governor Masaaki Shirakawa said on Tuesday that keeping Japan's interest rates low for too long could entice investors to take excessive risks, and warned of increased upward risks to inflation.

But while Shirakawa said that growth was likely to pick up in late 2008 and in 2009, he said there were downside risks. [ID:nL03608440]

Investors are also looking towards an auction of 10-year inflation-indexed JGBs on Thursday.

The Ministry of Finance's offer of 500 billion yen ($4.75 billion) in consumer price index-linked bonds is seen as likely to draw stronger demand than Tuesday's 10-year JGB auction, which met with tepid demand.

In March, the break-even inflation rate, or the difference between the yield on benchmark fixed 10-year JGBs and CPI-linked JGBs, fell into negative territory as index-linked paper was battered by overseas-investor selling.

But it has since recovered to around 35 to 40 basis points as the recent surge in oil prices to record highs fuelled concerns about inflationary pressures.

The fact that oil prices CLc1 have retreated from record highs hit in late May could curb demand at the auction, said Morita at Barclays Capital.