TOKYO, Aug 21 (Reuters) Japanese government bond futures eased off 17-month highs while the yield o

TOKYO, Aug 21 (Reuters) Japanese government bond futures eased off 17-month highs while the yield on two-year cash bonds inched up on Tuesday as investors took respite from the market's recent sharp rally.

The JGB market fell the previous session when stocks bounced back as the Federal Reserve on Friday cut its discount rate and helped soothe investor nerves about a deteriorating squeeze in credit markets.

Shorter-dated U.S. Treasuries led government bonds higher on Monday as credit concerns drove a bid for safe-haven securities and traders braced for an imminent cut in U.S. benchmark rates.

The Nikkei was up marginally, rising 0.7 percent in early trade.

''Relief inspired by the Fed's discount rate cut appears to be short-lived, and expectations are growing for a cut in the fed funds rate target,'' said a dealer at a Japanese securities firm.

''A Fed rate cut would make it harder for the Bank of Japan to raise rates. At the same time, the possibility for a BOJ rate hike before the year-end remains, making Japanese investors wary of building long JGB positions at current yield levels,'' the dealer said.

September 10-year futures inched down 0.04 point to 135.81 pulling back from the 17-month peak of 136.31 struck on Friday, when the lead contract posted its biggest one-day gain in nearly four years.

The two-year yield inched up 1.5 basis points to 0.845 percent.

The benchmark 10-year yield eased 1 basis point to 1.575.

In the money market, the BOJ offered to supply 800 billion yen ($7 billion) to the banking system as the overnight call rate hovered above the BOJ's 0.5 percent target. The same-day funding operation followed 1 trillion yen injected to the markets on Monday.

Money market rates overseas have been rising sharply over the past week as concerns about the global credit squeeze and banks have intensified, pushing the three-month LIBOR rate up by about 10 basis points to 1.0175 percent.

The rise in LIBOR has spilled over to yen swap spreads, keeping the two-year swap rates at about 1.1 percent or about 25 basis points above the two-year yield.

The BOJ holds its policy meeting Wednesday and Thursday this week, and swap contracts on the overnight call rate were showing a 15 percent chance of a rate increase this week and roughly a 50 percent chance of a move in September, according to data from interdealer broker Meitan Tradition.

Just a few weeks ago the BOJ had been widely expected to raise rates to a decade high 0.75 percent this month from the current 0.5 percent.

($1=114.33 Yen) Reuters CS VP0647