Smooth Japan bond auction soothes market jitters after global yield surge

• Global 30-year yields surged this week on fiscal worries
• Japan's MOF had reduced long-dated issuance to cap yields
• Political shifts in Tokyo may drive risk premia higher

By Rocky Swift and Kevin Buckland

TOKYO, Sept 4 (Reuters) - A closely watched auction of 30-year Japanese government bonds passed smoothly on Thursday, helping soothe investor nerves after yields were swept up to record highs this week on global worries about growing fiscal deficits.

A measure of demand at the sale called the bid-to-cover ratio, although on the low side, was not far from long-run averages for the tenor, and only the lowest since June.

The yield on the 30-year JGB JP30YTN=JBTC sank 4 basis points (bps) to a session low of 3.24% following the auction results.

The 10-year yield JP10YTN=JBTC dropped 3 bps to 1.6%, also a session low.

Bond yields rise when prices fall.

On Wednesday, the 30-year JGB yield shot up 8.5 bps to a record 3.285%, after scaling a series of peaks in recent months, driven by political uncertainty and lack of demand at home, and the gravitational pull of rising long-term yields globally.

"Given the sharp selloff in the 30-year yesterday, short-covering had been underway from the morning session, and the auction ended up passing smoothly," said Hirofumi Suzuki, a strategist at SMBC.

"That said, political uncertainty in Japan also continues, so upward pressure on Japanese yields is likely to persist."

The JGB market was dealt a blow in mid-July when the coalition of fiscally hawkish Prime Minister Shigeru Ishiba was clobbered in upper house elections. Outsider parties campaigning on tax cuts and increased spending gained seats, and speculation has swirled that Ishiba's Liberal Democratic Party (LDP) will call a leadership vote and choose a leader more willing to loosen the fiscal purse.

Ishiba has pledged to stay on. But even with no immediate political shake-ups, the nation's budget requests for the next fiscal year amounted to a record for the third straight year, the finance ministry said on Wednesday.

And the eventual amount could go higher, as local media reported that Ishiba plans to ask ministers to compile an economic stimulus package to be funded by an extra budget.

"We think risk premia will be politically driven and expect them to move higher if concerns about expansionary fiscal policy intensify and decline if those concerns ease," Takahiro Otsuka, senior fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities, wrote in a note.

Thirty-year bonds have become a pain point not only in Japan, but for the United States and across Europe as investors demand ever higher yields to hold debt for longer with no signs of improvement in the sovereigns' balance sheets.

Yields on 30-year debt recently hit a seven-week high in the U.S., a more than 16-year high in France, a 14-year peak in Germany, and levels not seen since 1998 in Britain.

Japan is often looked to as a test case for developed countries in how to cope with an ageing population, massive amounts of debt to service, and a need to wean the economy off central bank stimulus. Although JGB yields have risen sharply of late, they remain low relative to other major sovereign issuers.

"Not only Japan but in Europe and the U.S., people have a steepening bias right now," said Toshinobu Chiba, a Tokyo-based fund manager at Simplex Asset Management. "People don't want to take that longer duration risk."

If Japan's ruling LDP calls a leadership vote, the 30-year JGB yield may drift higher to about 3.8%, Chiba said.

JGB yields began to surge in late May, particularly on the longer end of the curve, as diminishing demand among life insurers and other traditional buyers led to poor results at debt auctions.

To cap yields and help reset the supply-demand balance, the MOF reduced issuance of some long-dated tenors, starting in July. Market sources told Reuters last week the ministry has been sounding out primary dealers about another reduction of long-dated bond sales.

"Notwithstanding periodic commentary about an absence of buyers and lingering fiscal concerns, volatility in the term premium on super-long JGBs has declined appreciably," said Shoki Omori, chief desk strategist at Mizuho Securities.

"The contraction in issuance size has been instrumental in fostering this improvement."

($1 = 147.3300 yen)

Yields rise, worries follow