Japanese government bonds fell on Friday as a nearly 2 percent jump in the Nikkei share average and an overnight slide in US Treasuries helped push futures further away from a 19-month high touched earlier in the week.
Demand for government debt slipped on signs that credit markets were stabilising from a liquidity shortage in the past month due to problems in the US subprime mortgage market.
"Some recent flight-to-quality buying in JGBs was unwound as global stock markets have started to calm down," said Naomi Hasegawa, a senior fixed-income strategist at Mitsubishi UFJ Securities.
JGBs trimmed sharp losses in afternoon trade, however, as some investors cut short positions before a three-day weekend in Japan, helping yields to fall from one-week highs hit earlier in the session. Japanese financial markets will be closed on Monday for a national holiday. Trade will resume on Tuesday.
"No one wants to be caught with short positions before the long weekend, especially ahead of policy meetings by the Federal Reserve and the Bank of Japan next week," said a trader at a Japanese brokerage.
The US central bank is expected to cut its benchmark fed funds rate, currently at 5.25 percent, by at least 25 basis points on Tuesday.
The BOJ is seen holding rates steady the following day due to recent volatility in financial markets and after a surprise resignation announced by Japan's Prime Minister Shinzo Abe earlier this week that has deepened political uncertainty.
December futures slid 0.25 point to 135.97, after falling as far as 135.70.
Futures edged further away from 136.41 hit on Wednesday, the highest for a lead contract since February 2006, as the Nikkei average jumped 1.9 percent.
The yield on the benchmark 10-year JGB was 1.5 basis points higher at 1.540 percent, after jumping to a one-week high of 1.580 percent. The yield had slid to a 19-month low of 1.50 percent earlier in the week.
The two-year yield was unchanged on the day at 0.785 percent, widening the 10-year/two-year spread to around 76 basis points. The five-year yield rose 2.5 basis points to 1.105 percent as demand for a new issue auctioned earlier in the week remained sluggish. The 20-year yield edged down 0.5 basis point to 2.085 percent.
FED AWAITED:
Treasuries fell on Thursday when weekly data showing a smaller decline in the commercial paper market cooled some expectations of a 50 basis point rate cut by the Fed.
The commercial paper market shrank $8.2 billion in the week to September 12, much less than a $54.1 billion contraction in the previous week and the smallest decline since the start of the credit crunch in early August.
JGBs followed Treasuries lower but analysts expect the JGB market to stay supported on anticipation the Fed could lower rates by as much as 50 basis points given the credit crunch and signs of weakness in the US economy, even as inflation risks remain.
A cut in the fed funds rate would make it hard for the Bank of Japan to lift rates from 0.5 percent, but some think there is still a slight chance that the Japanese central bank could lift its overnight rate before the year-end. Swap contracts on the overnight rate show around a 10 percent chance of a BOJ rate rise this month, while the chance of a December rise is around 35 percent.
Government officials expressed concerns on Friday about a possible delay in economic policy debate after Abe's resignation. Abe said on Wednesday he was quitting over a stalemate in parliament, but officials said health problems were also a factor. He was admitted to hospital on Thursday for a gastrointestinal disorder as well as stress and exhaustion.
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