TOKYO, July 27 (Reuters) – Japanese government bonds gained on Tuesday, with futures climbing towards a seven-year peak, as investor purchases of superlongs before the month’s end added to a flattening in the yield curve.

A 2.6 trillion yen ($29.9 billion) auction of two-year government debt attracted solid demand, with the market increasingly secure in the view that the Bank of Japan will either keep rates low for the foreseeable future or ease monetary policy further.

The 0.2 percent coupon auction produced the highest bid-to-cover ratio in five years, at 5.67 from 4.31 at the last sale in June. [ID:nMOFG15004]

“The higher-than-expected lowest price at the auction suggests investors bid directly in the primary market instead of going through brokerages,” said Keiko Onogi, a senior JGB strategist at Daiwa Securities Capital Markets.

“It reflects deepening easing expectations, enhanced after the Fed’s stance last week.”

The market is focused on an uncertain outlook for the global economy now that Europe’s bank stress tests are out of the way.

Fewer-than-expected banks failed the stress tests but the JGB market reaction was limited with concerns about the banking system remaining amid criticism the tests may have been too lax.

Indicators in focus include U.S. June durable goods orders due on Wednesday and second quarter GDP on Friday.

Federal Reserve Chairman Ben Bernanke fuelled speculation of further easing last week when he said the U.S. economy faced “unusually uncertain” prospects, and Treasuries rallied with the 10-year note yield US10YT=RR falling to a 15-month low.

Market players said how Treasuries fare may be key for the JGB market.

“Treasuries are holding firm considering that U.S. stocks are doing relatively well, supported by prospects for further easing,” said Makoto Noji, a senior market analyst at Mizuho Securities.

“How Treasuries perform will be key, as a rise in U.S. long-term rates may drive the yen lower (against the dollar) and in turn lift stocks and hurt JGBs. On the other hand, a further decline in U.S. long-term rates would have the opposite effect.”

September 10-year futures 2JGBv1 gained 0.12 point to 141.86 after hitting a seven-year peak of 142.08 last week.

Trade in futures was thin at around 18,800 lots, compared to last week’s daily average of 23,300 lots.

The five-year yield JP5YTN=JBTC edged down 0.5 basis point to 0.345 percent.

The benchmark 10-year yield JP10YTN=JBTC fell 1 basis point to 1.050 percent, edging closer to a seven-year low of 1.045 percent hit last week.

The 20-year yield dropped 2.5 basis points to 1.745 percent.

Purchases by index-following pension funds pulled down superlong yields, said a dealer at a foreign securities house.

The five-year/20-year yield spread tightened by 2 basis points to 140 basis points, its flattest in a year.

Duration extensions by index players at the month’s end have added to flattening pressure on the yield curve, as investors like domestic banks buy more superlongs for their higher returns. (Editing by Edwina Gibbs)