Japanese government bonds fell on Monday, with 10-year futures pulling back from a 17-month high as the Federal Reserve's surprise cut in its discount rate soothed investor nerves and helped equity markets bounce back.
The Fed's cut in the rate for banks borrowing funds from the central bank helped alleviate fears of a deteriorating squeeze in credit markets that had sparked a sell-off in risky assets such as stocks and higher-yielding currencies.
The Nikkei share average ended up 3 percent, booking its largest one-day percentage gain in 13 months on Monday, rebounding from its biggest one-day drop since just after the September 11 attacks on Friday.
Analysts said it was far from clear whether the Fed's action would be enough to calm the market storm caused by the US subprime mortgage crisis that has strained credit markets and even the willingness of banks to lend funds to each other.
Naomi Hasegawa, a senior fixed-income strategist at Mitsubishi UFJ Securities, said the Fed's action was seen as a first step, and any cut in the benchmark fed funds rate at its September meeting could make things tricky for the Bank of Japan.
The BoJ is widely seen leaving rates on hold at a two-day meeting ending on Thursday this week and expectations for a move in September have also dwindled. The next Fed meeting is on September 18, a day before the BoJ ends a two-day meeting on September 19.
"While more market participants believe the Fed will cut the fed funds rate, it is unlikely the BoJ will raise rates at the same time," Hasegawa said. Over the weekend Japanese newspapers reported that the BoJ was unlikely to raise interest rates at its policy meeting this week after the Fed's move and with financial markets still unsettled.
September 10-year futures ended the day session down 0.42 point at 135.85 pulling back from the 17-month peak of 136.31 struck on Friday, when the lead contract posted its biggest one-day gain in nearly four years.
The benchmark 10-year yield climbed 1 basis point to 1.585 percent, after briefly hitting a five-month low of 1.575 percent hit on Friday. The 20-year yield eased 2 basis points to 2.030 percent, while the five-year yield rose 3.5 basis points to 1.125 percent.
"The market is very quiet and there are very few flows from investors," said a senior trader at a European investment bank, adding that some market players were looking to put on positions betting on the yield curve to start flattening again.
The spread between five- and 20-year yields shrank 5.5 basis points to 90.5 basis points after having widened last week back near its steepest levels this year.
The Fed cut the discount rate 50 basis points to 5.75 percent and said in a statement that downside risks to growth had increased "appreciably", stoking expectations that a cut in the federal funds rate is coming at its next policy meeting.
Even though Japanese financial firms have reported little exposure to the US mortgage market woes so far, the sell-off in the Nikkei and a sharp rally in the yen had squashed expectations for a BoJ move at its two-day policy meeting ending on Thursday.
Swap contracts on the overnight call rate were showing a 15 to 20 percent chance of a rate increase this week and roughly a 50 percent chance of a move in September, according to data from interdealer broker Meitan Tradition. Just a few weeks ago the BoJ had been widely expected to raise rates to a decade high 0.75 percent this month from the current 0.5 percent.