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TOKYO, May 16 (Reuters) - Japanese government bonds edged lower on Tuesday, underpinned by decent demand at a five-year auction but pressured by rising U.S. Treasury yields as well as expectations that Japan's central bank will continue to pare its JGB buying.
The benchmark 10-year cash JGB added 1 basis point to 0.045 percent, while 10-year JGB futures edged down 0.07 point to close at 150.61.
The two-year yield rose 1 basis point to minus 0.165 percent, its highest level since December 2016.
"One of the reasons is that the BOJ has been tapering its purchases in the two-year sector, so a lot of dealers who held inventory of two-year JGBs are unwinding their positions," said Tadashi Matsukawa, head of fixed income investment in Tokyo at PineBridge Investments.
The Bank of Japan has been reducing the amount of JGBs it buys in some zones in recent weeks, putting the bank on track to fall short of its official guidance to increase bond holding by 80 trillion yen a year, and highlighting a growing discrepancy between what the BOJ says it will do in its official policy statement and what it actually does in its market operations.
"A lot of dealers were betting for the steepening of the yield curve, so they were kind of caught off guard," Matsukawa said. "And also, we had a five-year auction today, and some of the selling in the two-year sector was done in order to use up inventory at the short end of the curve."
At the Ministry of Finance's sale of 2.2 trillion yen ($19.39 billion) of five-year JGBs with a 0.1 percent coupon, some 41.5877 percent of the bids were accepted at the lowest price of 101.040.
The sale drew bids of 3.59 times the amount offered, up from the previous sale's bid-to-cover ratio of 3.28 times and from 2.86 at March's five-year sale.
The tail between the average and lowest accepted prices narrowed to 0.2, compared with that of last month's offering at 0.04, suggesting stronger demand for the bonds.
The benchmark 10-year U.S. Treasury yield has largely held in a range between around 2.20 percent and 2.40 percent since late March, investors wait on further clarity on whether President Donald Trump's administration is likely to pass tax and fiscal overhauls this year.
U.S. Treasury yields drifted higher on Monday as investors evaluated how many times the Federal Reserve was likely to raise rates this year.
By contrast, many market participants expect the BOJ's next move to be a withdrawal, not an expansion, of stimulus as global demand has given the domestic economy a lift.
BOJ Governor Haruhiko Kuroda said on Tuesday he was "quite sure" the central bank could smoothly exit from its massive monetary stimulus when the appropriate time to do so came.
But he also said the BOJ "always" had room to expand monetary stimulus to achieve its 2 percent inflation target, indicating that wages and prices had been slow to respond to improvements in the economy. ($1 = 113.4600 yen) (Reporting by Tokyo markets team; Editing by Simon Cameron-Moore)