Source; www.bloomberg.com

By Ron Harui

Oct. 29 (Bloomberg) -- Japan's five-year government bonds surged, posting their biggest gain since 1999, after the Nikkei newspaper said the central bank is ``leaning toward'' cutting interest rates by a quarter-percentage point.

Yields fell to a three-week low after the Nikkei said the Bank of Japan may lower its overnight rate to 0.25 percent from 0.5 percent at a scheduled policy meeting on Oct. 31, without citing anyone. The odds of a rate reduction this week jumped to 46 percent from 8 percent yesterday, according to calculations by JPMorgan Chase & Co. using overnight swaps.

``This news is bond-positive,'' said Alessio Caldarera, a debt strategist in Tokyo at BNP Paribas Securities Japan Ltd., a unit of France's biggest bank. ``You can expect monetary policy expectations to affect the curve further out,'' especially the five-year sector, he said.

The yield on the five-year note slid 13.5 basis points, the most since February 1999, to 0.92 percent at 4:10 p.m. in Tokyo at Japan Bond Trading Co., the nation's largest interdealer debt broker. The price gained 0.633 yen to 101.306 yen. The yield touched 0.88 percent, the lowest level since April 16.

The 10-year bond yield dropped 5.5 basis points to 1.485 percent and 10-year bond futures for December delivery advanced 0.65 to 137.90 at the close of the Tokyo Stock Exchange.

Yoshihiro Sugimoto, chief press officer at the Bank of Japan, declined to comment on the Nikkei report.

Japan's central bank is likely to cut its benchmark interest rate by a quarter point to 0.25 percent on Oct. 31, Tomoko Fujii, head of economics and strategy at Bank of America Corp. in Tokyo, wrote in a research note yesterday.

``Lower JGB yields are expected,'' said Fujii in an e-mail today to Bloomberg News, confirming the note.

The five-year yield may fall to 0.73 percent and the 10- year yield may drop to 1.30 percent by year-end, Fujii forecast.

Stock Rally

The gain in bonds was tempered after the Nikkei 225 Stock Average climbed 7.7 percent, damping demand for the relative safety of government debt.

Some investors sold Japanese bonds after Treasuries slumped yesterday on speculation the U.S. will increase debt issuance. A senior Treasury official said the U.S. faces ``unprecedented'' financing needs and may sell more long-term bonds to meet them.

The Nikkei 225 gained for a second day after the Standard & Poor's 500 Index yesterday climbed 10.8 percent and the Dow Jones Industrial Average surged 10.9 percent.

Japanese bonds typically move in the opposite direction to stocks. Benchmark 10-year yields had a correlation of 0.83 with the Nikkei 225 last week, according to data compiled by Bloomberg. A value of 1 would mean the two moved in lockstep.

Production Outlook

Ten-year notes also gained after a government report today showed Japanese companies plan to cut production this month and next as the global financial crisis increases the likelihood of a worldwide recession.

``Definitely it's economic fundamentals,'' said Guthrie Williamson, a portfolio manager in Sydney at Principal Global Investors, which manages $228 billion in assets globally. ``I've been bullish on JGBs since May. There have been dips at times that have presented buying opportunities in recent weeks.''

The 10-year bond yield may decline to 1.2 percent by year- end, Williamson said.

Industrial production will fall 2.3 percent in October and 2.2 percent the following month, according to the Trade Ministry report. Output climbed 1.2 percent in September from August, when it declined 3.5 percent, the steepest decline in five years, the report also showed. The government downgraded its assessment of production.

To contact the reporter on this story: Ron Harui in Singapore at rharui@bloomberg.net.