By Theresa Barraclough Nov. 17 (Bloomberg) -- Japan’s 10-year government bonds rose for a sixth day, heading for their longest rally this year, on speculation deepening deflation will encourage the Bank of Japan to keep interest rates near zero. Benchmark yields dropped to the lowest level in a month after a report yesterday showed the domestic demand deflator, a measure of prices that excludes imports, fell the most since 1958. Bonds also gained after Japanese Finance Minister Hirohisa Fujii reaffirmed a pledge to restrain the issuance of debt. “Expectations of the government declaring the nation in deflation may put pressure on the Bank of Japan” to keep rates low, said Akito Fukunaga, a strategist at Credit Suisse Group AG in Tokyo. “It’s definitely supportive for the bond market.” The yield on the 1.4 percent bond due September 2019 fell three basis points, or 0.03 percentage point, to 1.3 percent as of 12:37 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The price rose 0.263 yen to 100.871. The yield is the lowest since Oct. 14. Five-year yields lost three basis points to 0.585 percent, the lowest since Oct. 8. Twenty-year yields also dropped three basis points to 2.05 percent, a level unseen since Oct. 14. Ten-year bond futures for December delivery advanced 0.35 to 139.21 at the Tokyo Stock Exchange. The domestic demand deflator fell 2.6 percent in the third quarter from a year earlier, Cabinet Office figures showed yesterday in Tokyo. Deepening Deflation The difference between rates on five-year notes and inflation-linked debt, which reflects the outlook among traders for consumer prices over the term of the securities, was negative 0.91 percentage point today. Inflation-adjusted securities typically yield less than regular bonds because their principal payment increases at the same rate as inflation. Deflation, a general drop in prices, enhances the value of the fixed payments from bonds. The Bank of Japan last month forecast falling prices will persist through fiscal 2011. Japan’s government may declare the nation is in deflation, Nikkei Telecom said yesterday. There is a 10 percent chance the central bank will boost borrowing costs by the middle of next year, according to calculations by JPMorgan Chase & Co. using overnight interest- rate swaps. BOJ policy makers are scheduled to commence their two-day meeting on Nov. 19. Yen, Stocks The yen’s 6 percent gain against the dollar in the past three months has exacerbated the price slump by making imports cheaper. Japan’s currency traded at 89.06 per dollar today from 94.50 three months ago. “A stronger yen and a weaker dollar work against the Nikkei, but that’s positive for bonds,” said Eiji Dohke, chief strategist in Tokyo at UBS Securities Japan Ltd., one of the 23 primary dealers that are required to bid at government bond auctions. “I expect a mini rally in bonds toward December.” The Nikkei 225 Stock Average fell 0.6 percent today, extending its drop since Sept. 30 to 4 percent. Ten-year yields had a correlation of 0.89 with the Nikkei 225 in the past week, compared with a relationship of 0.62 last month, according to Bloomberg data. A value of 1 means the two moved in lock step. Ten-year bond yields reached the highest since June last week as supply concerns hurt demand for bonds. Japanese debt maturing in more than 10 years has handed investors a loss of 2.6 percent since Dec. 31, as measured by Merrill Lynch & Co. indexes, heading for the worst year since 2003. “If the government were to sell bonds in a sloppy way, that would be a big problem,” Finance Minister Fujii said at a news conference in Tokyo today. He reiterated that next year’s issuances shouldn’t exceed the record 44 trillion yen ($494 billion) budgeted for the current period ending March 2010. Japan’s debt burden will climb to twice the size of the economy next year, according to the Organization for Economic Cooperation and Development. To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.

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