Japanese government bond futures slid to a two-month trough on Monday as Tokyo share prices hit five-month highs, stoking worries that the Bank of Japan could raise interest rates before the year-end. The benchmark 10-year yield climbed to a two-month peak as the Nikkei average booked its highest close since mid-May.
"Bond investors took their cue from higher share prices, while the JGB market is quiet overall" said Hiroyoshi Sandaya, a JGB strategist at Goldman Sachs.
Investors speculate that a strong performance in the stock market could boost business sentiment among firms, making it easier for the central bank to further tighten monetary policy.
The BoJ lifted the overnight call rate to 0.25 percent from zero in July in its first rate increase in six years. BoJ Governor Toshihiko Fukui said earlier this month he could not ruled out another rate rise before the year-end. Fukui's comments helped JGB prices to slump as investors factored in the risk of a rate rise later this year, though that is still a minority view in the market.
Market players sold longer-dated paper to make room in their portfolios ahead of the Finance Ministry's auction of 800 billion yen ($6.73 billion) in 20-year JGBs on Tuesday.
But few market participants were concerned about the 20-year auction as it was seen likely to draw decent demand from investors such as life insurers, traders said.
In a recent interview series with Reuters, Japan's top nine life insurers said they were willing to pick up domestic bonds in the October-March second half of the financial year.
Many of the insurers said they were likely to focus on longer-dated issues, such as 20-year JGBs, when they buy more bonds to extend the durations of their yen bond holdings. December futures fell 0.29 point to 133.27 after slipping to a two-month low of 133.23.
The 10-year yield was up four basis points at 1.835 percent after touching a two-month high of 1.840 percent. The 20-year yield was three basis points higher at 2.290 percent, also a two-month peak. Investors are seen turning active buyers if the 10-year yield climbs further towards two percent or the 20-year yield exceeds the 2.3 percent mark, traders said.
"Few players think JGB prices will plunge from the current levels given expected investor demand, though the market may take a little more time before it rebounds," said a trader at a European brokerage. The two-year yield rose 1.5 basis point to 0.795 percent but was off a two-month peak of 0.810 percent hit last week. The JGB yield curve steepened as a result.
The yield curve flattened last week as short- to medium-term sectors were sold while the longer end was supported by demand from pension funds. Shorter maturities took a hit on chances that if prices rise and the economy grows in line with BoJ projections, a rate rise before the end of 2006 cannot be ruled out.
"Some investors may be seeing current long-term bond yield levels as not sufficiently reflecting the strength of the economy," said Akihiko Yokoyama, chief JGB strategist at J.P. Morgan Securities. "Such thinking may be leading to a correction in the yield curve, which flattened last week."
The JGB market, which has had a high correlation with the US Treasury market, failed to get impetus as Treasuries were virtually flat, with investors taking to the sidelines ahead of the Federal Reserve's policy meeting ending on Wednesday.
In the short-term money market, the three-month euroyen futures contract for December expiry rose 0.5 basis point to 99.415, indicating a three-month interbank rate of 0.58 percent by then, compared with roughly 0.44 percent now. Such an implied rate shows the market has still not fully priced in a rate rise this year.
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