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BLBG: Japan's Bonds Fall as Demand May Wane at Sale of Inflation Debt
By Theresa Barraclough

Oct. 7 (Bloomberg) -- Japan's government bonds fell for the first time in three days on speculation demand will wane at an auction of 300 billion yen ($3 billion) in 10-year inflation- linked debt tomorrow, prompting primary dealers to sell.

The difference in yield on the inflation notes and regular debt more than trebled in the past two months to minus 72 basis points, signaling traders don't expect consumer prices to rise. Bonds slid as the Nikkei 225 Stock Average pared losses after dropping below 10,000 for the first time in almost five-years. The Bank of Japan kept interest rates at 0.5 percent today.

``There's some hedge selling,'' said Koji Shimamoto, chief strategist at BNP Paribas Securities Japan Ltd. in Tokyo and the top-rated fixed-income analyst in Japan, according to the Nikkei Veritas newspaper. ``It will be a difficult auction.''

The yield on the 1.5 percent bond due September 2018 gained 3 basis points to 1.405 percent as of 1 p.m. in Tokyo at Japan Bond Trading Co., the nation's largest interdealer debt broker. The price fell 0.265 yen to 100.828 yen.

Yields on similar-maturity inflation-protected securities were unchanged at 2.097 percent after gaining for the past five days. A basis point is 0.01 percentage point.

Ten-year bond futures for December delivery dropped 0.57 to 137.98 at the Tokyo Stock Exchange. The Nikkei 225 was down 1.5 percent, paring a decline of as much as 5.3 percent.

``The Nikkei has rebounded from under 10,000, which is driving bonds down,'' Shimamoto said.

Inflation Note Sale

Primary dealers, who are obliged to bid at government sales, tend to reduce holdings in case prices decline before they can pass on the new securities to investors.

The prior sale on Aug. 7 drew bids worth 2.53 times the amount on offer, the lowest so-called bid-to-cover ratio since June 2005. Last year's average was 4.09 times.

Yields on the linked notes exceed those on conventional debt by the most since the securities were introduced in March 2004. They averaged 45 basis points less last year, according to data compiled by Bloomberg News.

The securities typically yield less than regular bonds because their principal payments increase at the same rate as inflation. The gap in yields of the two securities, known as the breakeven rate, reflects traders' inflation expectations over the term of the debt.

Policy Meeting

The economy has been and will continue to be ``sluggish,'' the central bank said after keeping interest rates at 0.5 percent, the lowest among major economies. Governor Masaaki Shirakawa will speak at a press conference at 3:30 p.m.

Demand for debt may increase as traders add to bets the Bank of Japan will reduce rates this year. European Central Bank President Jean-Claude Trichet last week said his board discussed cutting interest rates, fueling speculation that central bankers in Europe, the U.S. and Japan will lower borrowing costs to shore up the global economy.

``Government bonds are the safest products,'' said Takashi Nishimura, an analyst at Mitsubishi UFJ Securities Co., a unit of Japan's largest bank by assets, in Tokyo. Should Shirakawa say that inflation is ebbing, it's kind of a ``preparation for a rate cut. Shirakawa has to address the current mess of the financial crisis.''

There is a 32 percent chance the BOJ will reduce its target rate to 0.25 percent from 0.5 percent by year-end, compared with 3 percent about a week ago, according to calculations by JPMorgan Chase & Co. using overnight swaps.

Banks around the world are hoarding funds, crippling money markets in the U.S. and Europe as the crisis that brought down Lehman Brothers Holdings Inc. spreads. The Bank of Japan added 1 trillion yen to the financial system to help revive lending.

``Japan was a minor player in the whole subprime mess and it feels some liquidity crunch in sympathy,'' said John Richards, head of debt strategy for the Asia-Pacific region at RBS Securities Japan Ltd. in Tokyo, one of the 24 dealers that are required to bid at auctions. ``Japan is guilty by association.''

Japan's overnight call loan rate traded at 0.52 percent after the operation at 9:20 a.m. in Tokyo, from 0.53 percent before the injection, according to Tokyo Tanshi Co.

To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.