Longer-dated Japanese government bonds slipped on Friday, giving back earlier gains in jittery trade ahead of next week's 10-year offering and nudged lower by stronger Tokyo stocks.
JGBs had risen across the board in early trade following a record 1.1 percent drop in Japan's nation-wide May consumer price index and after US Treasuries gained on strong demand for seven-year notes and an unexpected jump in US jobless claims. The lead September 10-year futures trimmed gains as Tokyo stocks edged higher, while the yield curve gradually took on a distorted shape as the rise in the benchmark cash 10-year yield outpaced the rest.
"The futures are susceptible to profit taking, with participants wary of pushing the contracts further up after this week's rally," said a trader at a Japanese trust bank. September futures rose 0.03 point to 137.66 after hitting 137.87, their highest since early April.
The short-end extended gains after Thursday's 2.4 trillion yen ($25 billion) two-year JGB auction, which attracted solid demand from cash rich investors despite a 400 billion yen issuance increase.
But 10-year JGBs underperformed ahead of next week's auction of the maturity, which will be raised by 200 billion yen to 2.1 trillion yen. The increase is part of Japan's effort to issue an additional 16.9 trillion yen of debt for the fiscal year ending in March 2010 to pay for stimulus packages intended to help an economy in recession.
The market is closely watching how next week's auction will proceed as 10-year JGBs do not have the same kind of core buy-and-hold clientele as other points on the yield curve, though banks and institutions are active in the maturity.
Ten-year JGB yields were also nudged up by paying in the interest rate swaps market. Paying in swaps - which pushes up swap rates relative to bond yields but takes yields with it - was tied to banks hedging interest-rate risk related to equity-linked structured products, analysts said.
Market players are keeping an eye out for primary dealers paying in swaps next week to hedge their books before the 10-year auction, seen as a big test of demand with the increase in issuance.
The 10-year swap spread briefly turned positive on Friday for the first time since January, in a sign that conditions are starting to improve after financial market turmoil last year drove swap spreads negative at the long end. The cash two-year yield fell 1 basis point to 0.310 percent after dipping to 0.305 percent, its lowest since February 2006. The two-year yield has been anchored down by the Bank of Japan's easy monetary policy, which has increased purchases of the maturity by banks thanks to overnight interest rates near zero and increased money supply.
A Reuters poll of over 20 economists showed the central bank keeping interest rates, currently at 0.10 percent, on hold until the end of next year with Japan's economic recovery expected to be anaemic. The five-year yield was unchanged at 0.720 percent. The 10-year yield climbed 1.5 basis points to 1.395 percent and the 20-year yield fell 0.5 basis point to 2.075 percent. The 30-year yield was steady at 2.225 percent.
The spread between two- and 10-year yields widened by 2.5 basis points to 108.5 basis points. It touched a three-year high of 118.5 basis points early in June along with the jump in long-term yields.
"Different factors are driving the shorter-dated zones and the longer maturities," Credit Suisse interest rate strategist Kenro Kawano wrote in a note. "Steepening of the yield curve is likely to continue as investors' funds find their way to the short to midterm maturities, while concerns over deteriorating fiscal conditions are increasing in the longer-dated sectors."
Tokyo's Nikkei stock average gained 0.8 percent after jumping 2.2 percent on Thursday.
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