* Japanese investors in record buying binge in past 2 yrs
* Buying almost stopped after U.S. election
* Japanese selling could further destabilise market
* December seen risky month because of low market liquidity
By Hideyuki Sano
TOKYO, Dec 2 (Reuters) - Japanese investors' binge buying of U.S. bonds has come to an abrupt halt as they contend with the huge losses incurred when Donald Trump was elected president - triggering a wave of Treasury selling in the expectation of loose fiscal policies under the incoming administration.
Having bought some $290 billion of U.S. debt in the last two years, Japanese investors face double blows: First from the sharp falls in Treasury prices, and second because they paid sky-high premiums for currency hedging.
The cost of hedging has risen partly because of higher short-term dollar interest rates and, ironically, because Japanese investors face higher currency swap costs - caused by their huge demand for hedging.
In the near term the damaged portfolios are likely to limit risk appetite, with investors crystallising their losses potentially worsening already battered market sentiment, bond traders and investors say.
"If you were in charge of foreign bonds portfolios at a Japanese bank, it would be kind of a hell," said a derivative trader at a Japanese brokerage, who has long experience of trading foreign bonds.
"We've gone through a market where your year's worth of income gains are being wiped out in just three hours," the derivatives trader said.
With Japanese bond yields falling below zero after the Bank of Japan adopted negative rates earlier this year, Japanese investors have been major investors in U.S. bonds in 2016.
Bank of America Merrill Lynch's U.S. Treasury index fell 2.7 percent in November, its biggest fall since January's market turmoil, when it fell 3.1 percent.
For many foreign investors, falling bond prices were mitigated or even offset by the corresponding rise in the dollar. But for many Japanese investors the real return is worse because they have paid for currency hedging.
For instance, they typically paid around an annualised 1.6 percent to invest in 10-year U.S. Treasuries yielding 1.8 percent, leaving them a meagre return of 0.2 percent - a strategy that is attractive only for investors who have smaller bond returns at home.
"Our New York trading desk is very keen to know Japanese investors' flows... If they pull out, that is going to have a consequence for the markets," said a director of fixed income at a foreign brokerage, who spoke on the condition of anonymity.
Japanese investors became net sellers of foreign bonds in the week of Nov 14-18, selling 260.6 billion yen worth in their first net selling in seven weeks, Ministry of Finance data showed.
The following week, they bought 112.3 billion net, less than average weekly net buying of more than 500 billion yen so far this year.
The 10-year U.S. Treasuries yield stood near 16-month high of 2.41 percent on Friday, and some investors think they could snare a bargain by buying bonds after the surge in yields.
"U.S. bond yields have risen so much when we don't even know the line-up of Trump's cabinet. So to me all the talk that rising inflation justifies the rise in yields seems a bit phoney," said Akira Takei, fund manager at Asset Management One.
"The market will be volatile for some time, but I think the yields have already hit a near-term peak."
And those still interested in Treasuries say there has not been any change in the fundamental reasons behind the stampede into U.S. bonds - the lack of decent returns on domestic bonds.
But with the end of 2016 approaching, a time when many institutions close their books, selling by Japanese investors trying to minimise their exposure could become a self-reinforcing avalanche of losses.
"If their selling continues in December, we could see nasty spiral, because in December many financial institutions limit their trading ahead of their book-closing at the end of year," said a trader at a Japanese bank. (Reporting by Hideyuki Sano; Editing by Eric Meijer)