* Japan front end rates flatten, demand from banks strong
* Market expects BOJ to extend corporate financing support
* JGB curve also stays flat, while wary of election outcome
By Vidya Ranganathan
SINGAPORE, July 13 (Reuters) - The front end of Japan's debt markets extended a bullish flattening trend on Monday, signalling investors' strong conviction that the Bank of Japan will not waver from its ultra-easy monetary policy when it meets this week.
The two-year Japanese government bond (JGB) yield has dropped to 0.23 percent from 0.37 a month ago, while the spread between 5- and 2-year bonds has narrowed from 49 basis points to 42 in the same period.
Analysts say a combination of factors has driven the flattening, which has pushed spreads in some parts of the curve to near record lows, including the weakness in sectors of the economy such as capital expenditure and employment, a rising stock market and the abundance of yen funds with Japanese banks.
Almost no one expects any change in the Bank of Japan's 0.1 percent policy rate when it ends the two-day meeting on Wednesday.
And the bullishness at the short end indicated a majority of market participants was also expecting the BOJ to extend its special corporate financing measures, such as its buying of commercial paper and corporate bonds from banks, beyond their September deadline.
"We have seen very strong demand in the short to intermediate sector of the Japanese fixed income market," said Chotaro Morita, chief strategist for Japan at Barclays.
"The market is positioned for them to postpone the end of those measures to December or next year," he said.
That broadly held dovish view on Japanese rates has been the reason for a sharp rally in euroyen futures. The June 2010 futures contract has moved to 99.535 from 99.47 at the end of last month, now implying 3-month rates at 0.465 in a year's time. Three-month yen rates are currently around 0.44 percent.
Analysts expect any tweaks to monetary settings this week will be merely technical, and the focus is more on whether the BOJ changes its inflation forecasts or lowers its growth estimates.
ELECTIONS AND THE CURVE
Japanese money markets barely reacted to Monday's news that Prime Minister Taro Aso plans to call a general election on Aug. 30, and the ruling Liberal Democratic Party also signalled it would go into elections under Aso's leadership.
Opinion polls show the opposition Democratic Party might win the election, ending half a century of nearly unbroken rule by the LDP.
Yet, although markets were not pricing it in, traders said there was a worry a Democratic Party win could end the flattening trend in JGBs.
"The Democratic Party will expand the stimulative policy. The market has fears the Democratic Party will be too expansive and that means the budget deficit will expand and the steepening factor will emerge," said Morita.
The spread between 10- and 2-year JGBs is 105 bps, closing in on the 100 mark that Japanese traders deem psychologically crucial and seen historically only during the extremes of quantitative easing or monetary tightening phases.
Barclays believes the market bullishness is close to levels that be considered euphoric and has in recent weeks advised investors to go short futures.
Credit Suisse strategist Akito Fukunaga however expects the flattening of the curve will be sustained, even if the lowest he expects 10-year JGB yields to hit is 1 percent, 31 bps below where they are now.
"We don't see any resistance at 100 bps," Fukunaga said. (Editing by Jan Dahinten)