* JGBs sag following drop in U.S. Treasuries
* Nikkei rally weighs further on JGBs
* Market remains cautious before BOJ, Fed meetings
* 20-yr JGB auction results seen as fair
By Shinichi Saoshiro
TOKYO, March 17 (Reuters) - Japanese government bonds retreated on Wednesday, with lead 10-year futures dropping towards a one-month low, hurt by a rally in Tokyo shares and a drop in U.S. Treasuries the previous day.
The Nikkei stock average surged 3.2 percent, boosted by improved sentiment towards the global financial sector and mounting hopes for policy steps by the Bank of Japan and the U.S. Federal Reserve.
Caution prevailed in the bond market ahead of those meetings.
Of key interest to JGB investors this week is whether the BOJ, whose two-day meeting ends on Wednesday, will decide to increase the amount of government bonds its buys.
The BOJ currently buys 1.4 trillion yen of JGBs from the market per month.
A newspaper said over the weekend that the central bank will consider increasing that by another 100 billion yen to 200 billion yen to shore up the economy.
The report caught financial markets by surprise and JGBs gained on Monday, but the market has yet to reach a full consensus as to whether the BOJ will increase its bond buying amount at this stage.
Many market players had thought the BOJ would hold back on any new steps this week after a string of moves to ease the corporate credit crunch and rate cuts last October and again in December.
"The market is looking at a 50 percent chance of BOJ action this time," said a chief manager of the bond trading group at a Japanese bank.
Other central banks are also thought to be eyeing government bond buying as a way to bolster their economies, as the traditional tool of cutting short-term rates has been rendered practically useless with rates already near historic lows.
"The impact could be limited if the BOJ decides not to increase its JGB purchase amount, as many participants were not expecting such a move this week," said Keiko Onogi, a senior JGB strategist at Daiwa Securities SMBC.
"But if the BOJ does decide to increase, then it will likely provide significant support to JGBs," Onogi said.
June 10-year futures fell 0.33 point to 138.58, not far from a one-month low of 138.34 touched last week.
The five-year yield climbed 2 basis points to a one-month high of 0.770 percent.
The benchmark 10-year yield edged up 0.5 basis point to 1.305 percent after rising as high as 1.315 percent in early trade.
The 900 billion yen in 20-year JGBs offered by the Ministry on Finance on Tuesday drew fair demand amid the bond market's retreat.
The bid-to-cover ratio at the auction, a common gauge of demand, dipped to 2.69 from 3.12 at the previous tender last month.
But analysts were relieved to see the auction's lowest price was in line with earlier expectations and said the new 20-years drew demand from domestic investors such as life insurers as they continued to extend durations of their bond holdings.
The 20-year yield was up 3 basis points at 1.925 percent but traders said the move was due more to selling by dealers adjusting their inventories after the auction rather than a weakness in investor demand.
In addition to the BOJ's policy meeting, the JGB market will be watching the Federal Reserve meeting to see how it addresses the possibility of buying long-dated U.S. Treasuries.
U.S. Treasuries fell on Monday ahead of a two-day Federal Reserve meeting starting later in the day and as stock market gains dampened safe-haven bids for government bonds. (Additional reporting by Satomi Noguchi; Editing by Edwina Gibbs)