JGB 10-yr yield hits 3-month low as yen hurts stocks

* Yen hits 8-mth high vs dollar, stokes deflation concerns

* Yield curve flattens, longer dated JGBs better bid

* Shorter dated JGB yields seen nearing bottom for now

* Two-year/20-year spread tightest in more than 2 months

TOKYO, Sept 28 - Japanese government bonds gained on Monday, with the benchmark 10-year yield dropping to its lowest in nearly three months, as the yen's surge to an eight-month high against the dollar buffeted the Nikkei stock average and fanned deflation concerns.

A stronger Japanese currency reduces the cost of imported goods, which in turn can push down consumer prices and fuel deflation.

"If allowed to persist, the yen's appreciation will exert a flattening bias on the yield curve. Compared to short and midterm JGBs, the yields of longer dated maturities have more room to decline," said Naomi Hasegawa, a senior fixed-incomes strategist at Mitsubishi UFJ Securities.

December 10-year JGB futures climbed 0.27 point to 139.31 after hitting 139.40, their highest since the beginning of the month.

Two- and five-year yields are already hovering just above four-year lows and some domestic banks moved along the curve to buy longer dated JGBs, market players said, causing the 10-year yield to fall more relative to other maturities.

Two- and five-year yields have been firmly anchored by heavy purchases from Japan's banks, who have used these JGBs to park their funds, which have been swollen by slow lending growth and the central bank's easy monetary policy.

But analysts also do not see two- and five-year yields declining much further unless the Bank of Japan, which is already keeping interest rates at a low 0.10 percent, decides to loosen monetary policy further.

Superlongs slightly lagged the 10-year zone JGBs partially on uncertainty over supply, with the novice government under the newly elected Democratic Party of Japan being watched to see how much extra debt it will have to issue to fund a supplementary budget for the the fiscal year through March 2010.

Longer dated JGBs, particularly superlongs, are seen as more vulnerable to supply increase worries as they benefit the least from the BOJ's easy monetary policy.

There was some focus on whether strong receiving in longer dated interest rate swaps would emerge in reaction to the yen's advance but market players said such activity was yet to reach levels seen during previous yen surges earlier in the month.

Dealers who sold currency-linked structured products to investors often receive in interest rate swaps to hedge against exposure created when these products turn into long-term yen securities after certain currency levels are breached.

"There was receiving linked to structured products but not in volumes to attract strong attention or to match prior expectations," said a derivatives trader at a domestic bank.

TWO-YR/20-YR SPREAD TIGHTEST IN OVER TWO MONTHS

The two-year/20-year spread narrowed by 2.5 basis points on Monday to 179 basis points, its tightest in more than two months according to Reuters data.

Ahead of an auction of the maturities on Tuesday the two-year yield edged up 1 basis point to 0.220 percent, within sight of a four-year low of 0.200 percent struck earlier in the month.

The five-year yield was unchanged at 0.580 percent, not far from a four-year low of 0.560 percent touched earlier in the month.

The benchmark 10-year yield declined 3 basis points to 1.280 percent, its lowest since July 9.

The 20-year yield fell 1.5 basis point to 2.010 percent and the 30-year yield also dropped 1.5 basis points, to 2.145 percent.

The dollar touched an eight-month low below 89 yen on Monday with Japanese Finance Minister Hirohisa Fujii's earlier comments that the new government would not pursue a weak yen policy helping the Japanese currency.

The Nikkei slid 2.5 percent to a two-month closing low with exporters hit by the yen's appreciation.