JGBs flat; yen, stocks eyed as deflation deepens

TOKYO, Sept 29 - Japanese government bonds were little changed on Tuesday as the market took a breather after the previous day's gains, with a bounce by the Nikkei stock average from a two-month low capping bond prices.

* The market eyed developments in currencies and stocks for near term incentives after the yen pulled back from eight-month highs against the dollar and pushed the Nikkei up 1 percent.

* Gains by U.S. Treasuries the previous day and the latest indication of deepening Japan deflation helped underpin JGBs. Data released on Tuesday showed Japan's core consumer prices fell a record 2.4 percent in August from a year earlier.

* The yen's run to an eight-month high against the dollar on Monday had fanned deflationary concerns. The dollar fell as low as 88.23 yen on trading platform EBS on Monday before edging back to around 90 yen on Tuesday.

* Analysts said two- and five-year JGB yields, already hovering just above four-year lows, had little room to fall further despite deepening deflation unless the Bank of Japan were to ease its already loose monetary policy even more.

* "The yen may have to gain significantly more, say below 85 yen (against the dollar) before it has a more lasting impact on bond yields," said Tetsuya Miura, chief market analyst at Mizuho Securities.

* Yields of longer dated maturities, on the other hand, are in theory seen to have scope for further declines under deflationary conditions. But caution towards a potential supply increase expected to fund the government's supplementary budget later in the fiscal year have prevented a sharp drop in yields.

* The immediate market focus was on Tuesday's 2.4 trillion yen ($26.7 billion) two-year JGB auction. The Ministry of Finance set the coupon at 0.2 percent, the lowest since the December 2005 issue, but analysts expect ample demand from banks due to the Bank of Japan's easy monetary policy and deflationary pressures. The auction results will be released at 0345 GMT.

* Deflation is not good for inflation-linked JGBs, which were sold heavily during the financial market turmoil a year ago as foreign investors dumped the instruments in haste to secure cash.

* The break-even-inflation (BEI) rate, the difference between yields on benchmark 10-year JGBs and those on linkers of the same maturity, sank below minus 3 percent early in the year before edging steadily back to minus 1 percent earlier this month, as financial market conditions have improved. But JGB dealers and investors have recently asked the MOF to continue its purchases of outstanding linkers to prop up the market.

* December 10-year JGB futures edged up 0.01 point to 139.32 after hitting 139.40 on Monday, their highest since Sept. 3.

* The benchmark 10-year yield was unchanged at 1.280 percent after brushing a three-month low of 1.275 percent.

* The five-year yield climbed 1 basis point to 0.585 percent after hitting a four-year low of 0.560 percent earlier in the month.

The two-year yield rose 0.5 basis point to 0.230 percent. It had touched a four-year low of 0.200 percent earlier in the month.