JAPANESE banks are set to be among the biggest losers from the continuing weakness in bond markets after yesterday’s government bond auction failed to stimulate demand.

Benchmark ten-year bond yields, which are the inverse of prices, continued their upward spiral yesterday, hitting a 14-month high of 1.4 per cent.

The banks, in the throes of dealing with Y44.4 trillion (£231 billion) of debt, were the biggest investors in bonds in the first part of the year, before the collapse of the market, helping to drive yields to a record low of 0.43 per cent.

The fall in the Japanese bond market is part of a global trend marked by investors switching funds into equities in expectation of economic recovery. Analysts said bank losses from the recent rout in global bond markets would be compounded by yesterday’s lacklustre sale. Banks held about Y87 trillion in bonds at the end of June, treble their holding of five years ago.

Although losses on bond investments are likely to hamper banks’ recovery, analysts said that some of the losses would be offset by recent stock gains.

Yesterday the Nikkei 225 ended above the key 10,000 level for a second successive session, closing up 1.41 per cent, or 141.13 points, at 10,174.10, a new high for this calendar year and more than 30 per cent above the twodecade low hit in April.

Japanese economists said that the weak result of the auction would not prevent the Government from holding two more next month. However, they said that higher long-term yields did not bode well for Japan’s nascent economic recovery and bond instability would keep banks risk-averse and money supply stagnant.

Soichi Okuda, Aozora Bank economist, said: “With the Nikkei around 10,000 and ten-year bond yields at 1.4 per cent, I think they would be carrying latent losses now. Sell bonds and sell banking shares could become the next trend for hedge funds.”

Takehiro Sato, a Morgan Stanley analyst based in Tokyo, said: “The Government is not unduly worried about the auction. In fact, some think that it was not as bad as expected.” He said that the Government’s focus was on the more optimistic growth forecasts. A recent survey of 20 banks found that most had revised their Japanese growth forecasts upwards for 2003.

Mr Sato said that the speed with which the banking sector dealt with their non-performing loans would be critical to any continued recovery in the economy. The huge bad debt pile has constrained Japanese banks from lending money in recent years — one of the only ways that they can return to sustainable profitability.

He said the Government was considering the progress the banks were making in disposing of non-performing assets. The Bank of Japan wants them to dispose of half of non-performing loans by 2005.