JGBs edge up, futures hold near 18-month peak

TOKYO, Aug 22 (Reuters) - Japanese government bonds edged up on Wednesday, keeping 10-year futures pinned near an 18-month peak as ongoing problems in credit and money markets have pushed back expectations for a Bank of Japan interest rate hike.

JGBs have rallied sharply along with Treasuries as the fears about losses tied to U.S. subprime mortgages have caused the market for U.S. commercial paper to seize up, sending investors fleeing for the safety of short-term bills.

Benchmark 10-year JGB yields have fallen about 40 basis points in the past six weeks to an 18-month low of 1.540 percent, back to levels last seen when the BOJ raised overnight interest rates from zero last year.

''Right now, market sentiment has dramatically changed and yields can go even lower,'' said Kenro Kawano, an interest-rate strategist at Credit Suisse.

The 10-year yield fell 1.5 basis points to 1.545 percent.

September 10-year futures climbed 0.11 point to 136.21, pushing back near the high of 136.46 struck in the evening session on Tuesday -- the highest since February 2006.

The sell-off in risky assets and volatility in markets has shifted expectations for a BOJ rate increase to later in the year at the earliest. Many had been expecting a rise at the two-day policy meeting ending on Thursday.

The BOJ is seen keeping rates on hold at 0.5 percent but wanting to continue normalising monetary policy as long as the financial market distress does not undermine the economy.

Swap contracts on the overnight call rate show just a 10 percent chance of a BOJ increase this week and roughly a 50 percent chance of a move in September or October, according to data from Meitan Tradition The swap contracts are now only fully pricing in one rate increase by the end of the fiscal year to next March, which Koji Ochiai, a senior market analyst at Mizuho Securities, has called overly pessimistic.

The rush for ultra-safe short-term government bills and worries about the exposure of banks has caused other money market rates such as LIBOR to rise sharply, pushing up yen LIBOR rates, the swaps market and even short-term yields.

U.S. money markets settled down a bit on Tuesday after a frantic drop in bill yields the previous day as signs mounted of funds having to sell assets as they were unable to roll over their short-term funding needs tied to commercial paper.

That helped three-month yen LIBOR to be fixed at 1.005 percent from 1.0175 percent the previous day, the highest since July 1995.

The three-month LIBOR rate was still well above the three-month financing bill yield of 0.690 percent Kawano at Credit Suisse said the jump in yen LIBOR could be sustained for a few more weeks but would then likely fall back.

Two-year yen swap rates were steady near 1.09 percent, keeping the spread over two-year JGB yields relatively wide at about 25 basis points. The two-year cash yield dipped half a basis point to 0.835 percent.

Data on Wednesday showed Japan's trade surplus fell a bigger-than-expected 21 percent in July from a year earlier to 671 billion yen, with imports and weak shipments to the United States offsetting record exports to Asia and Europe.

Reuters CS VP0655