Japanese government bonds surged on Friday as investors speculated that the Bank of Japan may not lift interest rates this month, given that tightening in global credit markets has cranked up market volatility.
JGB futures posted the largest one-day rise since August 2006 on a sell-off in shares and gains in US Treasuries, which rallied on Thursday and Friday as investors sold riskier assets such as stocks and credit in favour of safer government debt.
The credit squeeze caused by problems in the US mortgage market dried up liquidity in money markets, prompting the European Central Bank to conduct its largest-ever cash injection on Thursday. Other central banks also provides funds to their markets.
Such moves underlined the severity of current market conditions and prompted flight-to-quality buying of bonds. Analysts said it was becoming increasingly difficult for the BOJ to raise rates this month, as investors had been expecting.
"Central banks are not supposed to be tightening credit when markets are in complete disarray," said John Richards, head of Asia-Pacific Strategy at RBS Securities.
"And this is close to a complete disarray." Swap contracts on the overnight call rate showed roughly a 30 percent chance that the BOJ will lift rates by 25 basis points to 0.75 percent in August, dropping from as high as 75 percent at one point on Thursday. Swap contracts showed about a 65 percent chance of a September rate hike.
September futures ended the regular session up 0.90 point at 134.28. The lead contract rose as high as 134.36 in the evening session, the highest since late May.
September futures posted the biggest one-day rise as a lead contract since August last year, when a surprisingly big downward revision to the consumer price index triggered a big rally in JGBs.
The benchmark 10-year JGB yield dropped as much as 8 basis points to 1.705 percent, a 2-1/2-month low, before pulling back slightly to 1.715 percent. The two-year yield fell 9 basis points to 0.935 percent, a 2-month low. The five-year yield tumbled 10.5 basis points to 1.285 percent after striking a fresh 2-1/2-month low of 1.280 percent.
The strain on credit markets was evident in short-term swap spreads, with the two-year swap spread pushing out a basis point, while the five-year spread expanded two basis points. Ten-year spreads were largely unchanged at 19/20 basis points, traders said.
The Nikkei share average ended down 2.37 percent at 16,764.09, its lowest close in almost 5 months. Treasuries rose on Thursday, helping shorter maturities to post their strongest daily performance in three years after the Dow Jones industrial average sank nearly three percent. Deteriorating credit conditions have increased speculation of a rate cut by the Federal Reserve, with Fed fund futures suggesting an growing possibility that the central bank may lower rates from 5.25 percent as early as in September, which would likely make it hard for the BOJ to lift rates.
Lead March euroyen futures jumped 10 basis points to 99.060, posting the biggest one-day gain since August 2006. The contract hit a 2-1/2-month high of 99.065 earlier in the day.
"Euroyen futures and swap contracts on the overnight call rate have been swinging violently, reflecting the panicky tone in the market," said a trader at a European brokerage.
Overnight call funds traded at 0.49/0.50 percent, according to data from Central Tanshi and Tokyo Tanshi, near the BOJ's 0.5 percent target and slightly lower from the weighted average of 0.517 percent on Thursday. The BOJ offered to supply 1.0 trillion yen ($8.5 billion) in funds on a same-day basis to quell a rise in the call rate, in a move that came as little surprise to the market.
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