By Yasuhiko Seki Aug. 22 (Bloomberg) -- Japanese bonds completed a second- straight weekly advance as regional equities dropped, boosting demand for the relative safety of government debt. Ten-year yields yesterday approached the lowest in a month on concern China will tighten monetary policy, curbing the record lending that’s fueled a 60 percent rally in the nation’s stock market. China may increase capital requirements for banks, three people familiar with the matter told Bloomberg News. “There is real uncertainty over how far global stocks can extend their rally, given the tenuous outlook for the Chinese market,” said Ryutaro Matsuyama, a Tokyo-based strategist at Mizuho Investors Securities Co., one of the 23 primary dealers which are required to bid at government bond auction. “If this doubt persists, bonds have a good chance of rising further.” The yield on benchmark 10-year bonds dropped seven basis points to 1.305 percent this week at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The yield touched yesterday 1.300 percent, the lowest since July 13. The price of the 1.5 percent bond due in June 2019 rose 0.614 to 101.696 yen. A basis point is 0.01 percentage point. Ten-year bond futures for September delivery rose 1.22 from last week to 139.20 yen at the Tokyo Stock Exchange. The Nikkei 225 Stock Average fell 3.4 percent this week, completing its first weekly decline in six weeks. Japan’s bonds often move in the opposite direction to stocks. Benchmark 10- year yields had a correlation of 0.57 with the Nikkei 225 this month, according to data compiled by Bloomberg. A value of 1 means the two moved in lockstep. Investors who bought 10-year debt at the start of this month made a return of 1.2 percent through yesterday, according to a data compiled by Bloomberg. The Nikkei 225 has lost more than one percent since the end of July. China’s Stocks The Shanghai Composite Index, tracking the bigger of China’s exchanges, has lost 2.8 percent this week. On Aug. 19, it fell 19.8 percent below its Aug. 4 high and near the 20 percent bear-market threshold, amid disappointing earnings and concern the government will seek to damp property speculation. “There are lingering concerns about policy actions in China, and if Chinese authorities move to tighten policies, risk-aversion may strengthen further,” Mizuho’s Matsuyama said. The China Banking Regulatory Commission sent a draft of rule changes to banks on Aug. 19 requiring them to deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital, said people who have seen the document. Banks have until Aug. 25 to give feedback, said the people, who declined to be identified as the matter is private. Deflation Outlook Ten-year bonds also logged the first back-to-back weekly advance in a month before a government report economists say will show Japan’s consumer prices slumped last month. Prices excluding fresh food probably declined by a record 2.2 percent from a year earlier after sliding 1.7 percent in June, according to a Bloomberg News survey of economists. The statistics bureau will release the data on Aug. 28. “Growing speculation that deflation will accelerate will strengthen the view that interest rates won’t rise soon,” said Hirokata Kusaba, senior economist in Tokyo at Mizuho Research Institute Ltd., a unit of Japan’s second-largest banking group by asset. “This view, combined by fragile nature of the ongoing recovery in Japan, will support the debt market.” Bank of Japan board member Atsushi Mizuno said Aug. 20 the central bank may consider setting preconditions for ending its policy of keeping interest rates near zero should the economy deteriorate and deflation take hold. “It is an option to show our commitment to keep interest rates at extremely low levels should we judge that the economy and prices will get worse,” Mizuno said in a speech in Okayama, western Japan. A sustainable recovery is “highly uncertain.” 20-Year Auction Demand for longer-dated debt was limited on speculation dealers will reduce bond holdings in preparation for next week’s auction of 1.1 trillion yen ($11.7 billion) in 20-year notes. The yield spread between five- and 20-year securities expanded to 1.475 percentage points yesterday, the widest since August 2005. Primary dealers, which are required to bid at government bond sales, often reduce bond holdings in case prices decline before they can pass on the new securities to investors. “Shorter-dated notes are in good demand as investors have a strong belief in the prolonged easing by the Bank of Japan,” said Katsutoshi Inadome, a Tokyo-based strategist at Mitsubishi UFJ Securities Co., a unit of Japan’s biggest banking group. “Concerns about fiscal risks weigh on the longer-dated debt.” The Bank of Japan flooded the short-term money market with funds between 2001 and 2006 to keep the overnight call rate effectively at zero in so-called quantitative easing operations. The Ministry of Finance will sell 20-year notes on Aug. 25. The prior sale of such securities on July 22 drew bids worth 2.9 times the amount on offer, compared with a so-called bid-to- cover ratio of 3.6 times at the June auction. The ratio averaged 3.03 times over the past year. To contact the reporter on this story: Yasuhiko Seki in Tokyo at Yseki5@bloomberg.net

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