Investors have flocked to long-term bonds while shunning shorter debt, flattening the yield curve as the market prepares for the Bank of Japan to end its super-easy monetary policy by mid-2006.
That has pounded out the yield curve, pushing the two-year yield to a near five-year high, as shorter maturities are most vulnerable to a rise in the BoJ's overnight call money target rate.
Five-year notes reversed earlier losses after hitting a 16-month high last week, supported by demand from investors shedding long-term bonds.
Some analysts said the unwinding of the curve bet had been prompted after the Nikkei average took a breather following its climb to a 4-1/2-year high hit last week, which encouraged buying in JGB futures.
"The long end had gotten ridiculously flat over the past few days and this is simply a reaction," said John Richards, fixed income strategist at Barclays Capital. "And as flat as the curve has become, it doesn't take much selling to do the damage that has been done."
Key December 10-year JGB futures ended the day up 0.06 point at 136.11, moving away from a 15-month low hit on Friday after falling below 136 for the first time since early August 2004.
The 10-year yield was up two basis points at 1.625 percent, its highest since September 8 last year.
The five-year yield slipped 0.5 basis point to 0.960 percent after climbing to a 16-month high of 0.97 percent on Friday.
The two-year yield was flat at 0.325 percent but hovered near its highest level since February 2001, a month before the BoJ introduced its "quantitative easing" policy of flooding the markets with cash and pinning interest rates near zero.
The 30-year yield jumped six basis points to 2.395 percent while the 20-year yield rose four basis points to 2.105 percent.
The spread between 5- and 30-year yields flattened from 145.5 basis points a month ago to 110 basis points on Friday, when the 30-year yield fell to a new three-month low of 2.335 percent.
That marked the lowest spread since late 2003, according to some analysts.
The 10- to 20-year spread shrank to 45.5 basis points on Friday, the lowest since D The Nikkei ended down 0.10 percent after a rise on Friday that took it to its highest close since May 22, 2001.
Activity in short-term maturities was limited on Monday as investors prepared for an auction of 2 trillion yen ($16.90 billion) worth of five-year JGBs by the Ministry of Finance on Tuesday.
Traders said they expect a 1.0 percent coupon, which would be the highest since a 1.1 percent coupon on five-year JGBs in December 2000 and up from a 0.8 percent coupon last month.
Some analysts said buying in five-year bonds before the auction could be considered a sign of confidence that the offer would attract sufficient demand, particularly given the possibility of a relatively high coupon.
"We could see some demand if the coupon is set at 1 percent," said Hidenori Suezawa, chief fixed income strategist at Daiwa Securities SMBC.
But he said excess buying in five-year bonds between now and auction could drive the coupon down to 0.9 percent, and this was curbing buying demand for the moment.
Although investors are commonly attracted to higher coupons, some analysts said demand could be limited regardless of the coupon as institutional investors may shy away from shorter maturities ahead of an eventual end to the BoJ's easing policy.
"The biggest concern is that banks, which are the main buyers in the sector, may not be active at the auction," said Tatsuo Ichikawa, a Japan rates strategist at ABN Amro Securities.
Traders said market players were looking for September machinery orders and third-quarter economic growth data later in the week for clues to gauge whether a pickup in the economy could prompt the BoJ to end its policy earlier than expected.
The benchmark December 2006 euroyen interest rate futures was unchanged at 99.450, after falling to a five-year low on Friday. Current benchmark levels indicate a three-month interbank interest rate of 0.555 percent by that time.