* Fall in Nikkei, rebound in U.S. Treasuries underpin JGBs
* Inflation outlook seen holding key
* 2-year yield hit 1 1/2-yr high of 0.15 pct but slips back after auction
By Hideyuki Sano
TOKYO, May 30 (Reuters) - Japanese government bond prices gained on Thursday, as investors piled back into the debt market after another big fall in Tokyo stocks and a relatively strong auction of two-year JGBs.
The two-year bond yield hit a 1 1/2-year high on market positioning ahead of an auction of 2.9 trillion yen ($28.6 billion) two-year JGBs, though the yield fell back after auction results turned out to be strong.
"There's strong potential demand in the market. There are many investors who want to buy when the market calms down. You don't see the much-hyped portfolio adjustment (from bonds to stocks) at all," said Katsutoshi Inadome, fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities.
The yield on the benchmark 10-year JGBs fell 5.0 basis points to 0.890 percent, distancing itself further from a 13-month high of one percent hit a week ago.
Japanese shares fell 5.2 percent on Thursday, extending losses from a 5 1/2-year peak hit a week ago, hit by a rebounding yen and worries the U.S. stimulus could be rolled back this year.
The Nikkei share average, which had risen a whopping 53 percent at one point from the beginning of the year, started falling exactly on the day when the 10-year yield hit the symbolic one-percent peak last Thursday.
"Stocks can rise and the yen can fall only when bond yields are kept low. Financial markets are now looking for levels to settle down, with markets interacting with each other," said Akito Fukunaga, chief rates strategist at RBS Securities.
JGBs also had an additional lift from U.S. Treasuries, whose yields fell sharply from highs hit in Wednesday's Asian trade, helped by solid demand at a five-year notes sale.
The market showed no reaction to a series of comments Bank of Japan Governor Haruhiko Kuroda made in the parliament. He reiterated recent statements that he wanted to lower the volatility of the JGB market but also added that inflation expectations are rising.
The BOJ's pledge in April to boost inflation to two percent in two years is at the heart of market volatility, bond market participants say.
"Until April, everyone thought two percent inflation would be impossible. But now people think they cannot completely rule out that possibility," Fukunaga at RBS.
Analysts say JGB yields could rise further if investors grow more worried that inflation may rise faster than they are expecting.
Core nationwide inflation for April, due on Friday, is expected to have fallen 0.4 percent. But economists expect prices to turn positive later in the year to post a 0.3 percent rise in the fiscal 2013/14.
The BOJ's forecast is near the high end of market economists' forecast, with the median forecast by the central bank's board members for 2013/14 at 0.7 percent.
Some market players see signs the JGB's volatility may be coming down. July JGB futures options were hardly traded, even when just one day is left before front-end June options expires on Friday -- a highly unusual development.
"This suggests all the people who have bought options are now having a hard time and cannot rollover their positions to the next contracts," said a trader at a Japanese brokerage.
The two-year bond yield briefly rose to 0.150 percent , its highest since October 2011, ahead of the auction. But it fell back to 0.140 percent, flat on the day, after the auction drew strong demand.