Japanese Bonds Complete 2nd Weekly Gain as Deflation Deepens

June 27 (Bloomberg) -- Japan’s bonds gained for a second week as a government report showed consumer prices fell at a record pace, adding to signs deflation will hamper the economic recovery and boost the value of the fixed payments of debt.

Ten-year yields touched the lowest in almost three months after the statistics bureau said yesterday prices excluding fresh food fell 1.1 percent in May from a year ago. Bank of Japan Governor Masaaki Shirakawa said last week price declines will accelerate through the middle of the fiscal year as demand slackens and crude oil trades lower than last year’s record.

“The drop in consumer prices may accelerate to about 2 percent in the summer,” said Yuichi Kodama, chief economist in Tokyo at Meiji Yasuda Life Insurance Co., Japan’s third-largest life insurer. “The 10-year yield may decline to 1.3 percent or below as the market needs to prepare for deeper deflation.”

The yield on the benchmark 10-year note fell five basis points this week to 1.395 percent in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. It fell to 1.37 percent yesterday, the lowest since April 2. The price of the 1.5 percent debt due June 2019 gained 0.439 yen to 100.919 yen this week. A basis point is 0.01 percentage point.

Ten-year bond futures for September delivery rose 0.74 to 137.66 at the Tokyo Stock Exchange this week.

‘Extreme’ Drop

Worldwide inflation is easing as energy costs retreat and the worst global recession since the Great Depression prompts companies to discount. Consumer prices failed to rise in the euro area for the first time in at least a decade in May, and in the U.S. they fell 1.3 percent, the most since 1950. Deflation increases the value of the fixed payments on bonds.

An “extreme” slump in demand and production are causing the drop in prices, Finance Minister Kaoru Yosano said yesterday. “We continue to monitor developments in prices and need to carefully manage the economy to avoid a deflationary spiral.”

The Organization for Economic Cooperation and Development this week urged the Bank of Japan to keep pumping cash into the economy “until underlying inflation is firmly positive.” Since it cut the key interest rate to 0.1 percent in December, the central bank has been buying corporate debt and increased government bond purchases from lenders to revive growth.

Daily Loss

“Deepening deflation will support the view in the market that the super-loose monetary policy by the Bank of Japan will be sustained,” said Yasunari Ueno, chief market economist in Tokyo at Mizuho Securities Co. “I won’t change my projection that the 10-year yield will drop toward 1 percent.”

Still, 10-year bonds fell for a second day yesterday before a government report next week that economists said will show industrial output rose for a third month in May.

“The bond market may undergo a correction next week as forthcoming data may enhance economic optimism,” said Norikazu Hasegawa, a manager of the treasury division at Chiba Bank Ltd. in Tokyo. “The stable movement of stock prices indicates that the euphoria about the economy remains intact.”

The Nikkei 225 Stock Average rose 0.9 percent this week and the MSCI Asia Pacific Index of regional shares added 1.8 percent.

Industrial production rose 7 percent last month, following a 5.9 percent gain in April, according to a Bloomberg News survey of economists before the June 29 report.

Demand for bonds was also limited before a key survey of business confidence. The Bank of Japan’s Tankan index of sentiment among large manufacturers rose to minus 43 in June, from minus 58 in March, according to a separate Bloomberg survey of economists before the report is released on July 1.

Debt Sales

“It is now certain that Japan’s economy already bottomed out of the recent recession and it is now recovering,” said Taro Saito, a senior economist in Tokyo at NLI Research Institute Ltd., a unit of Japan’s biggest life insurer. “Yields may gradually trend higher.”

The Ministry of Finance will sell 2.1 trillion yen ($21.9 billion) in 10-year bonds on July 2, up from this month’s 1.9 trillion yen auction. The ministry in April said it would boost bond sales by 15 percent to 130.2 trillion yen this fiscal year.

“Given the potential risk of rising debt sales across the globe, Japan’s 10-year yield may reach 1.7 percent,” said Mitsumaru Kumagai, senior economist in Tokyo at Daiwa Institute of Research Ltd., a unit of Japan’s second-largest securities brokerage. “The Japanese economy may avoid slipping into a deflationary spiral.”