* Ten-year yield reaches two-month low of 0.685 pct
* Strong expectations of BOJ easing support markets
By Dominic Lau
TOKYO, Feb 26 (Reuters) - Japanese government bond prices rose on Tuesday, with the five-year yield hitting a record low, as Italy’s deadlocked election outcome raised fears the euro zone debt crisis could resurface.
Italy’s centre left won the lower house as widely expected but no party or likely coalition appeared likely to be able to form a majority in the upper house or Senate, creating a deadlocked parliament, which could threaten the country’s economic reforms and reignite the euro zone debt crisis.
Mounting expectations of more drastic easing steps from the Bank of Japan to revive the ailing economy also helped push yields down to levels that some analysts said were “overly priced in” by the markets.
“It’s very, very difficult to justify this yield level. But as the Federal Reserve has done something similar in the last few years, it’s possible for the central bank to engineer lower rates for longer,” said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch.
“That’s what is expected from the BOJ under this new regime under (Haruhiko) Kuroda-san or whoever it may be.”
The five-year yield inched down 0.5 basis point to 0.115 percent, breaking the previous low of 0.120 percent hit on Monday after sources said Asian Development Bank President Kuroda, an advocate of aggressive monetary easing, was likely to be nominated as the next BOJ chief.
The 10-year yield slipped 2 basis points to 0.685 percent, touching its lowest level since Dec. 6, while 10-year JGB futures climbed 17 ticks to 144.84 after climbing to a two-month high of 144.95.
Fujita said his model showed the markets had already priced in a 40 trillion-50 trillion yen ($426 billion-$533 billion) expansion of asset purchase by the central bank, a 5 basis points cut in interest rates on reserves and a 80 percent chance of lengthening the maturity of JGB purchases to five years from three.
The BOJ has already pledged to pump 101 trillion yen into the economy by the end of this year through its asset purchases and lending programme, and will shift to open-ended purchases from 2014.
The 30-year yield eased 2.5 basis points to 1.875 percent and the 20-year yield fell 1.5 basis points to 1.690 percent, tugging at a two-month low.