June 30 (Bloomberg) -- Japan's government bonds completed their worst quarter in more than a year on speculation the central bank will increase borrowing costs again by August.

Benchmark 10-year bonds dropped the most since the first three months of 2006 as reports signaled the economy is resilient enough to allow the Bank of Japan to raise interest rates. Trading was limited last week before the central bank's Tankan survey July 2, which may show business confidence held near a two-year high, said Naomi Hasegawa, a senior fixed-income strategist at Mitsubishi UFJ Securities Co.

``The economy looks good enough for many people to keep their expectations for higher borrowing costs,'' Tokyo-based Hasegawa said. ``People are refraining from aggressively trading as the central bank is scheduled to release the Tankan, which will give a wider picture of how the economy is doing.''

The yield on the benchmark 10-year bond rose 21.5 basis points this quarter to 1.865 percent at yesterday's close, according to Japan Bond Trading Co., the nation's largest interdealer debt broker.

The central bank raised rates twice to 0.5 percent since March 2006, when it ended its five-year deflation-fighting policy. Rates are still the lowest among major economies. The quarterly Tankan index of confidence probably held at 23 points in June, the bank is scheduled to say next week, according to a Bloomberg News survey.

Room for Selling

``Market participants would rather hold off from aggressively trading before an important report,'' said Atsushi Ito, a fixed-income strategist in Tokyo at Morgan Stanley Japan Securities Co., one of the 25 primary dealers required to bid at government debt sales. ``I see more room for bonds to be sold.''

Benchmark bonds have dropped more than the country's primary bond dealers anticipated when the quarter started.

Ten-year yields would be at 1.75 percent at the end of June, they forecast in April, according to the median estimate of a Bloomberg News survey. Deutsche Securities Inc., JPMorgan Securities Japan Co. and Lehman Brothers Japan Inc. said they would be at 1.9 percent, the closest to yesterday's level.

The decline in bond prices pushed yields as high as 1.985 percent on June 13, the most since July last year, as U.S. Treasuries led a global decline in debt on concern quickening economic growth will lead to higher interest rates.

Weekly Advance

Japanese bonds yesterday had the biggest gain in two weeks, completing a weekly advance, after a government report showed consumer prices in Tokyo unexpectedly declined.

Prices excluding fresh food in the capital, an indicator of the future direction of nationwide prices, unexpectedly fell 0.1 percent in June, the statistics bureau said. Economists expected a 0.1 percent gain. Bonds also rose yesterday as investors bought debt to match a monthly change in a benchmark index.

``It's unlikely for bond yields to keep climbing, given the outlook of the economy and inflation,'' said Akio Kato, senior portfolio manager in Tokyo at Kokusai Asset Management Co., which runs the world's second-biggest bond fund.

Nomura Securities Co. will add debt including 10- and 20- year securities sold this month to its Bond Performance Index in July and remove those due in a year and less. Money managers such as the Government Pension Investment Fund, which runs the world's largest pool of retirement wealth, use the index to decide on holdings.

``The month-end rebalancing of the index is prompting some buying,'' Ryohei Ajisaka, chief Japanese government bond strategist in Tokyo at Daiwa Securities SMBC Co., the largest buyer at government debt auctions.

Longest in 60 Years

A measure of Japanese inflation expectations held near a nine-month high this week.

The gap in yield between regular and inflation-linked bonds due in 10 years, the so-called breakeven rate, was 62 basis points yesterday, according to data compiled by Bloomberg. The spread, which shows what the market expects consumer prices to average in the next decade, rose to 64 basis points on June 8, the highest close since September.

``My view on the end of deflation hasn't changed,'' said Economic and Fiscal Policy Minister Hiroko Ota yesterday. Ota has said the end of deflation is in sight. The tighter labor market will fuel wage growth and eventually contribute to price gains, she said.

Reports in the past week indicated Japan's economy is likely to extend its longest expansion in 60 years.

Retail sales unexpectedly gained for the first time in eight months, the Trade Ministry said June 27. The jobless rate held at a nine-year low in May and household spending rose for a fifth month, separate reports showed yesterday.

The central bank will increase borrowing costs in August, Mitsubishi's Hasegawa said, adding that she maintained her forecast after yesterday's reports on consumer prices and employment.

To contact the reporter on this story: Issei Morita in Tokyo at imorita@bloomberg.net.

Last Updated: June 29, 2007 19:37 EDT