Higher yields attracted capital into the market, helping Japan's two-year government bond auction on Wednesday draw demand stronger than the 12-month average.

The bid-to-cover ratio rose to 3.89 from 2.97 at the previous auction, compared with a 12-month average of 3.75. In another sign of strong demand, the tail spread, the gap between the average price and the lowest accepted price, narrowed to 0.014 from 0.034 last month. Japanese bond futures pared their losses after the auction results were released.

Miki Den, senior rates strategist at SMBC Nikko Securities, said the auction produced a solid result thanks to the high yields. She added that the market is closely watching monetary policy in Japan and the United States, with the U.S. employment report due later this week as the core focus.

Notably, an earlier offering of 40-year Japanese government bonds also attracted the strongest demand since 2020. As a result, the two-year yield, which is sensitive to monetary policy expectations, fell 1.5 basis points on Wednesday to 1.945%. It had touched 1.975% earlier this week, the highest level since 1995, while the 10-year yield also retreated from a 30-year high to around 3.08%.

The auction came amid growing speculation that the Bank of Japan may raise interest rates again as early as next month. That follows the central bank's decision earlier this month to lift its benchmark rate to the highest level in 31 years. Kazuo Momma, former head of monetary policy at the Bank of Japan, also expressed this expectation in an interview.

Strategist Mark Cranfield said demand at today's two-year Japanese government bond auction was above the one-year average and did not repeat August's poor auction. He said the result will reassure Japanese and broader G-10 fixed-income markets. Although yields have yet to break above 2%, they are already attractive enough for investors to position along the short end of the curve. In addition, Mitsubishi UFJ Morgan Stanley Securities took down 22% of the bonds, which should help ensure active secondary market trading.

Overnight index swaps show about a 23% probability of a Bank of Japan rate hike in October, while a 25 basis point increase by December is almost fully priced in. Meanwhile, Japanese and U.S. policymakers have stepped up verbal intervention since last week to curb the yen's slide, which has also helped support market sentiment.