May 17 (Bloomberg) -- Japan's 10-year bonds rose after a government report showed deflation deepened more than expected, dousing speculation the central bank may reduce the amount of money in the banking system.

Ten-year bonds had their biggest drop in a week yesterday after the head of the Bank of Japan on May 13 told business executives a gain in consumer prices may increase the probability of a change in monetary policy. The speech raised speculation the central bank would adjust policy at meetings on May 19 and 20.

``The risk that the Bank of Japan would tighten policy this week is almost non-existent now,'' said Shinji Kunibe, a fund manager at the Japanese unit of J.P. Morgan Fleming Asset Management, which oversees $305 billion in assets. ``That's providing support for bonds.''

Benchmark 10-year government securities advanced 0.043 to 99.999 as of 5:29 p.m. in Tokyo. Their yield fell half a basis point, or 0.005 percentage point, to 1.30 percent. The 1.9 percent coupon bond due in 2025 rose 0.141 to 98.931, pushing its yield down 1 basis point to 1.975 percent.

Prices as measured by the deflator of gross domestic product declined 1.2 percent from a year earlier, a report by the Cabinet Office in Tokyo showed. Economists surveyed by Bloomberg predicted a 0.7 percent drop.

Japan's economy remains in mild deflation, Heizo Takenaka, minister for economic and fiscal policy, said at a regular press briefing today in Tokyo after the GDP report was released. Deflation increases the value of debt's fixed payments.

Deflation

The Bank of Japan isn't sure whether it can alter the policy in the next two years ending March 2007, Governor Toshihiko Fukui told a meeting of business executives in Tokyo on May 13. Should consumer prices rise in the year starting April 1 as the bank has projected, the chances of a change in policy will grow in the course of that year, he said.

Sakuya Fujiwara, a former Bank of Japan deputy governor for five years until March 2003, said last week the bank should consider changing its policy of pumping cash into the economy and holding rates at almost zero.

The central bank pushed interest rates to near zero percent in 2001 and said it would keep them there until a slide in consumer prices ended.

Growth Accelerates

Government securities fell earlier, pushing 10-year yields to a one-month high, after today's GDP report showed the economy grew at a 5.3 percent annual pace in the first quarter, twice as fast as economists forecast.

``The figure is much better than expected,'' said Naruki Nakamura, who helps manage the equivalent of $3.8 billion in bonds at Fischer Francis Trees & Watts in Tokyo, which is partly owned by BNP Paribas SA, France's second-biggest bank by assets. ``The initial reaction is a sell.''

On May 6, 10-year yields reached a 14-month low amid signs the economy was recovering from last year's fourth recession since 1991. A release last week showed machinery orders rose more than expected in March.

Bond futures for June delivery closed unchanged at the close of afternoon trading on the Tokyo Stock Exchange.

Demand at the government's 2 trillion yen ($18.8 billion) auction of five-year notes today fell as the government set the lowest payout since January on the securities.

The Ministry of Finance sold the notes with a 0.5 percent coupon. The rate was in line with the level forecast by all five traders and investors in a Bloomberg News survey.

The auction drew bids worth 3.96 times the amount of five- year notes auctioned, the lowest level since February's sale.

Japan has the largest sovereign bond market in the world, with 686 trillion yen in marketable securities, or $6.5 trillion, outstanding at the end of September, compared with $4.1 trillion in the U.S. at the end of March.

Profits Decline

Bonds also rose as stocks slid and forecasts from companies showed they expect current profit to decline this fiscal year.

A total of 970 Japanese companies that have reported earnings results for the year ended in March expect current profit to drop 2.1 percent this fiscal year, started April 1, after gaining 3.7 percent last fiscal year, according to data compiled by Bloomberg.

The figure is in contrast to forecast of a 3.3 percent increase in current profit this fiscal year, according to the Bank of Japan's quarterly Tankan survey released on April 1.

``Current profit forecasts were dreadful,'' said Christian Carrillo, Tokyo-based Japan rates strategist at ABN Amro Securities Japan Ltd., one of 28 primary dealers, which discuss bond sales with the Ministry of Finance. ``If today's growth figure was sustainable, we should be at around 1.6 percent'' for 10-year yields.

The Nikkei 225 Stock Average fell for a seventh day, its longest losing streak in seven months.

To contact the reporter on this story: Chris Cooper in Tokyo at ccooper1@bloomberg.net

Last Updated: May 17, 2005 04:32 EDT