By Shinichi Saoshiro

TOKYO, Aug 26 (Reuters) - Japanese government bonds slipped
on Thursday on profit-taking as U.S. Treasuries retreated and
after a Japanese ruling party heavyweight said he would challenge
the prime minister in a party leadership vote next month, raising
the prospect of the government's fiscal austerity stance being
dented.

But the Nikkei hovering just above a 16-month low and the yen
staying within distance of a 15-year high against the dollar
helped slow the retreat in JGBs.

Some see the rising yen, sliding stocks and falling JGB
yields as a sign investors are losing faith that officials will
take aggressive measures to fight deflation and revive the
economy.

Recent political developments could also erode faith towards
the authorities' capacity to tackle the yen and help the economy.

Japanese ruling party powerbroker Ichiro Ozawa said he would
run in a party leadership vote on Sept. 14 in a challenge to
Prime Minister Naoto Kan, risking a bitter battle within the
Democratic Party of Japan as it tries to deal with a soaring yen
and a fragile economic recovery.

"Some players took profits as thoughts turned to the ruling
party vote and after seeing Treasuries fall despite the downbeat
U.S. data," said Tetsuya Miura, chief market analyst at Mizuho
Securities.

"The latest political developments may slightly curb fiscal
austerity hopes, but bond yields remain in a downtrend on easing
expectations and lacklustre economic fundamentals."

U.S. Treasuries fell on Wednesday, succumbing to
profit-taking although weak durable goods orders and new home
sales data showed fresh signs of a decelerating U.S. economy.

The yen's rise to a 15-year high against the dollar this week
has turned up the heat on the BOJ to further ease monetary
policy.

The benchmark 10-year yield rose 3 basis points to 0.930
percent after hitting a seven-year low of 0.895 percent the
previous day.

The five-year yield edged up 0.5 basis point to 0.255
percent.

September 10-year futures fell 0.18 point to 142.88.

An auction of 2.6 trillion yen ($30.7 billion) two-year JGBs
attracted firm demand on Thursday although the 0.1 percent
coupon, which equals the BOJ's overnight call rate target, was
the lowest in five years.

The bid-to-cover ratio, a gauge of demand, dipped to 4.75
from 5.67 at the previous auction in July but was still
significantly higher than 3.78, the average ratio from the past
12 tenders.

Steady demand underscored investor expectations that the BOJ
will maintain a very loose policy for at least two years, the
duration of the paper.

In contrast to the steady short-end, superlong JGBs were hit
by profit taking from participants including domestic banks.

Banks had helped the recent bull flattening of the yield
curve by purchasing superlongs but are also willing to pocket
profits without much notice since they are not necessarily
buy-and-hold superlong investors like pension funds and life
insurers, traders say.

The five-year/20-year yield spread widened to 130.5 basis
points after hitting a 15-month low of 125.5 basis points on
Tuesday.
(Editing by Joseph Radford)