Feb. 18 (Bloomberg) -- Japanese 10-year bonds headed for the first weekly gain in three after a government report showed the economy contracted and the central bank kept policy unchanged at a meeting yesterday.

Bonds rose this week as a Feb. 16 report showed the economy shrank for the last three quarters of 2004. Bank of Japan Governor Toshihiko Fukui said the report ``confirmed that the economy remains on a plateau.'' The bank maintained its policy yesterday.

``Now is the time to be bullish on bonds,'' said Shinji Kunibe, a fund manager at J.P. Morgan Fleming Asset Management (Japan) Ltd., a subsidiary of J.P. Morgan Fleming Asset Management, which oversees $305 billion in assets. ``The Bank of Japan can't tighten policy with the economy contracting.''

The benchmark 1.3 percent bond due in December 2014 rose 0.043 to 99.179 as of 12:31 p.m. in Tokyo, according to Japan Bond Trading Co., the nation's largest debt broker. Its yield fell half a basis point, or 0.005 percentage point, to 1.395 percent.

Ten-year bond futures for March delivery rose 0.07 to 138.85 on the Tokyo Stock Exchange.

The economy contracted an annual 0.5 percent in the final quarter of 2004, the Cabinet Office said. It also shrank in the previous two quarters, revised figures showed.

Bonds may fall on speculation the Nikkei 225 Stock Average will extend its gain this year.

The Nikkei 225, which rose as much as 0.3 percent, is up 1.1 percent this year. Japanese benchmark 10-year bond yields, which move in the opposite direction of prices, had a correlation of 0.91 with the Nikkei 225 in the past two years, according to Bloomberg data. A value of 1 would mean the two move lock step.

Shrinking Economy

Fukui and the bank's eight other policy makers maintained their target for reserves available to lenders at between 30 trillion yen ($284 billion) and 35 trillion yen at their meeting yesterday, leaving interest rates close to zero. They kept monthly purchases of government bonds from lenders at 1.2 trillion yen.

``We discussed the issue at our board meeting, and we've concluded it's possible to maintain the target,'' Fukui said at a press conference yesterday in Tokyo following the bank's two-day board meeting. ``That's why we made today's policy decision.''

He said the central bank can maintain the reserve target even should the money market experience a seasonal shortage of funds in early March before the start of the fiscal year on April 1.

``Yields will continue to head downward,'' said Susumu Kato, chief fixed-income strategist for Asia at Lehman Brothers Japan Inc. in Tokyo, one of 26 primary dealers in Japan that attend meetings on bond sales with the Ministry of Finance. ``There will be no immediate policy change.''

Ten-year yields may fall to 1.375 percent today, Kato said.

No Policy Change

Japanese bank loans fell to 385 trillion yen in January, according to figures from the central bank. They have dropped more than 150 trillion yen since rising to a high of 537 trillion yen in March 1996.

``All the companies are paying down debt,'' said Richard Koo, chief economist at Nomura Securities Co.'s research institute. ``They're not borrowing money so whatever the level of interest rates are it doesn't matter. There is no demand for funds.''

The extra yield U.S. 10-year notes offer over similar maturity Japanese bonds was 2.78 percentage points yesterday. The average for the past year is 2.75 percentage points. The gap has narrowed from 3.36 percentage points on May 13.

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

Last Updated: February 17, 2005 22:39 EST