By Yasuhiko Seki Nov. 12 (Bloomberg) -- Japan’s 10-year government bonds rose the most since January after a report showed that producer prices dropped for a 10th month in October, underscoring the risk that deflation may undermine the economic recovery. Benchmarkyields declined to a one-week low as signs Japan will experience a long period of falling prices spurred demand at an auction of 2.4 trillion yen ($26.7 billion) in five-year notes today. The sale was 100 billion yen larger than last month’s as the Finance Ministry faces a shortage in revenue. “Prolonged deflation means that the Bank of Japan can’t possibly start hiking interest rates anytime soon,” said Takeshi Minami, chief economist in Tokyo at Norinchukin Research Institute Ltd. “This will give financial institutions with excess cash the confidence to buy government debt.” The yield of the benchmark 10-year bond fell 5.5 basis points, the biggest intra-day decline since January, to 1.375 percent as of 3:02 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The price of the 1.4 percent bond maturing in September 2019 rose 0.475 to 100.216 yen. A basis point is 0.01 percentage point. Ten-year bond futures for December delivery added 0.63 to 138.49 at the Tokyo Stock Exchange. The costs companies pay for energy and unfinished goods tumbled 6.7 percent from a year earlier in October after sliding a revised 8 percent in September, the Bank of Japan said today in Tokyo. The median estimate of 23 economists in a Bloomberg News survey was for a 6 percent drop. ‘Sticky’ Deflation Producer prices “have moved into a new phase of ‘home- made’ deflation linked to a lack of domestic demand,” said Kyohei Morita, chief economist at Barclays Capital in Tokyo. “Deflation may become less speedy but could also become more sticky.” The Bank of Japan last month forecast that both wholesale and consumer prices will continue to fall through the year ending March 2012, which would mark the third year of declines. Producer prices will probably drop 1.4 percent in the year ending March 2011 and 0.7 percent in the 12 months after, following this fiscal year’s estimated 5.2 percent slide, BOJ board members predicted in their semi-annual report. The central bank will keep the overnight call rate unchanged at 0.1 percent at least until the first quarter of 2011, according to a Bloomberg News survey of economists and analysts. Auction Demand Today’s auction attracted bids for 3.70 times the amount on offer, higher than the so-called bid-to-cover ratio of 2.17 times at the previous sales on Oct. 15, which was the lowest since September 2003. The lowest price at the auction was 0.02 yen below the average price, compared with a difference of 0.04 at last month’s sale. The so-called tail is the difference between the lowest and the average price. The shorter the tail, the more bids are clustered around the average price. The auction result “underscored that the recent downtrend of the JGB market bottomed out,” said Kenro Kawano, a fixed- income strategist at Credit Suisse Group AG in Tokyo. Ten-year yields reached 1.485 percent on Nov. 10, the highest since June 17. ‘Nowhere Else’ “Ultimately, there is nowhere else than the debt market where banks can spend their money when demand for new loans is weak,” Norinchukin’s Minami said. Lending, including those by credit associations, increased 1.5 percent in October from a year earlier, compared with 1.6 percent growth in September, the Bank of Japan said on Nov. 10. Shinsei Bank Ltd. said it boosted government bond holdings by 1.1 trillion yen in the fiscal first half ended in September as outstanding advances dropped nearly 500 billion yen. Debt sales will rise 2.1 trillion yen to a record 132.3 trillion yen in the fiscal year ending March 2010, the Finance Ministry said on Oct. 30. Finance Minister Hirohisa Fujii said Nov. 10 Japan’s worsening fiscal health is one reason bond yields have been increasing. Non-Japanese investors were net sellers of Japan’s notes for a fifth week, offering a net 215.6 billion yen in securities during the five days ended Nov. 6. They sold a net 346.8 billion yen in the previous period, the biggest net sales in a month, according to the Ministry of Finance in Tokyo. GDP Report “Support for bonds is weakening as the anxiety over deteriorating fiscal discipline is spreading,” said Takeo Okuhara, a fund manager in Tokyo at Daiwa SB Investments Ltd., a unit of Japan’s second-largest securities broker. “Receding concerns that Japan will have a double-dip recession are also an important factor keeping yields from falling.” Japan’s gross domestic product expanded at an annual 3 percent pace in the three months ended in September, faster than the 2.3 percent growth in the pervious quarter, according to a Bloomberg News survey of economists before the Cabinet Office releases the data on Nov. 16. To contact the reporter on this story: Yasuhiko Seki in Tokyo at Yseki5@bloomberg.net

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