Oct. 30 (Bloomberg) -- Japanese 10-year bonds completed their first monthly drop since July as stocks rallied after a report showed the U.S. economy returned to growth.

Ten-year yields touched the highest level in more than 11 weeks after the Nikkei 225 Stock Average surged, damping demand for government debt. U.S. Treasuries slid yesterday, widening their yield premium over Japanese debt. Bond losses were tempered as Japan’s central bank kept borrowing costs near zero and a government report showed consumer prices fell last month.

“A rebound in stocks pushes bond yields up,” said Jun Ishii, a fixed-income strategist at Mitsubishi UFJ Securities Co. in Tokyo and the top-rated debt analyst in Japan according to Nikkei Veritas newspaper.

The yield on the 1.3 percent bond due September 2019 rose 10.5 basis points this month to 1.4 percent at 4:12 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The yield, which earlier reached 1.425 percent, the highest since Aug. 12, was unchanged on the day.

Ten-year U.S. Treasury yields climbed eight basis points yesterday, expanding their advantage over similar-dated Japanese yields to 2.09 percentage points, Bloomberg data showed.

Japan’s bond futures for December delivery dropped 1.35 this month to 137.99 as of the afternoon close at the Tokyo Stock Exchange. The contracts fell 0.01 today.

“Bonds will test lower prices again after U.S. bonds sharply dropped on the back of higher stocks,” said Akihiko Inoue, chief market analyst in Tokyo at Mizuho Investors Securities Co., a unit of Japan’s second-largest bank.

Stock Gains

The Standard & Poor’s 500 Index increased 2.3 percent yesterday after a Commerce Department report showed that the world’s largest economy expanded at a 3.5 percent pace from July through September. The Nikkei 225 added 1.5 percent, the largest gain since Oct. 15.

Benchmark 10-year yields had a correlation of 0.8 with the Nikkei 225 in the past week, compared with a relationship of 0.2 last month, according to Bloomberg data. A value of 1 means the two moved in lock step.

Japan’s consumer prices excluding fresh food fell 2.3 percent in September from a year earlier, after dropping 2.4 percent the prior month in the sharpest decline since the survey began in 1971.

‘Downward Pressure’

“This confirms the downward pressure on prices from waning demand,” said Kenro Kawano, a fixed income strategist at Credit Suisse in Tokyo. “We can expect the Bank of Japan to leave interest rates on hold for a while.”

The difference between rates on five-year notes and inflation-linked debt, which reflects the outlook among traders for consumer prices over the term of the securities, was negative 1.22 percentage points today.

Inflation-adjusted securities typically yield less than regular bonds because their principal payment increases at the same rate as inflation. Deflation, a general drop in prices, enhances the value of the fixed payments from bonds.

Core prices will fall 1.5 percent in the year ending March 2010 and slide 0.8 percent in the following 12 months, the BOJ said in their semiannual outlook in Tokyo today.

There is a 11 percent chance Japanese policy makers will leave the overnight interest rate unchanged by the end of June, according to calculations by JPMorgan Chasse & Co. using overnight interest-rate swaps.

The Bank of Japan kept its key interest rate at 0.1 percent at today’s meeting. Policy makers decided to end purchases of commercial paper and corporate bonds from lenders as scheduled, while extending unlimited collateral-backed lending through March 31, the bank said in a statement released in Tokyo.

Governor Masaaki Shirakawa has said the need for debt purchases diminished as companies find it easier to borrow amid a recovery from Japan’s worst postwar recession. The credit programs have been in place since the bank slashed the benchmark interest rate to 0.1 percent in December amid the worst global financial crisis since the 1930s. The BOJ decided in July to extend the measures to Dec. 31.

To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.

Last Updated: October 30, 2009 03:25 EDT