TOKYO, Sept 28 (Reuters) - Japanese government bonds gained on Tuesday, with a sale of two-year debt attracting the strongest demand in five years, after a report of possible further policy easing by Japan's central bank and as anxiety over Ireland's finances supported debt globally.
The yield curve flattened as superlong bonds were supported by month-end duration extensions from some index-following investors, market players said.
Adding to speculation of further easing by the Bank of Japan, the Nikkei business daily reported that the central bank will consider pumping relatively longer-term funds into the money market to push down interest rates at its Oct. 4-5 meeting.
Sources have also told Reuters that the BOJ could loosen policy at that meeting if the economic recovery is deemed by the board to be under threat, with an increase in government bond buying and a further expansion in its cheap fund-supply tool emerging as the most likely options.
'Whether the BOJ eases this month or the next will likely depend on upcoming economic indicators,' said Hidenori Suezawa, chief strategist at Nikko Cordial Securities.
'Even if the central bank doesn't loosen policy at the next meeting, expectations that it will eventually do so will continue to support the market after the Fed made it clear that further easing is an option.'
Expectations that the BOJ will ease further increased last week after the Federal Reserve expressed stronger concerns about low inflation and signalled it was open to future policy loosening.
The bond market was also focused on the BOJ's quarterly survey of business sentiment due on Wednesday and how the yen's appreciation could have dented a recovery in sentiment at a time when expectations for further easing were rising.
TAIL-LESS AUCTION
Reflecting strong investor demand despite a modest 0.1 percent coupon, the bid-to-cover ratio, a gauge of demand, at Tuesday's 2.6 trillion yen ($30.8 billion) two-year JGB auction rose to a five-year high of 5.75 from 4.75 at the previous tender in August.
The auction came without a tail -- the difference between the lowest and average accepted prices and another gauge of demand -- for the first time in five years.
'Investors are not really in it for yields anymore. The short end offers a relatively risk free environment for them to park their excess cash, with the process made easier as both the BOJ and Fed could ease going forward,' said Keiko Onogi, a senior JGB strategist at Daiwa Securities Capital Markets.
Short-end JGBs are a staple for domestic investors like banks needing to park their excess cash resulting from sluggish lending and rising deposits.
December 10-year futures rose 0.22 point to 143.05, with a sizeable drop by Tokyo's Nikkei on Tuesday bringing the contract within distance of a seven-year peak of 143.14 hit last month.
The two-year yield edged down 0.5 basis point to 0.130 percent while the benchmark 10-year yield fell 3.5 basis points to 0.960 percent, after touching a one-month trough of 0.955 percent.
The 30-year yield fell 4.5 basis points to 1.820 percent.
The 10-year/30-year yield spread tightened to 86 basis points, pulling further away from a six-month peak above 90 basis points hit earlier this month.
U.S. and German government bonds rallied on Monday after credit agency Moody's slashed some debt ratings on Anglo Irish Bank, saying there was a risk Dublin might default on lower-grade loans issued by the nationalised lender.
(Editing by Chris Gallagher)
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