TOKYO, Sept 17 (Reuters) - Japanese government bond futures fell sharply on Wednesday as the Federal Reserve's rescue of insurer American International Group pushed up stocks and sapped demand for safe-haven government debt.

U.S. Treasury yields also rose in Asian trade, with the two-year note's yield jumping to 2 percent from 1.79 percent late Tuesday in New York.

The Fed said it would lend up to $85 billion to AIG for two years in exchange for the U.S. government taking a nearly 80 percent equity stake in the insurer.

While futures were due for a slide given their recent sharp gains that have made them expensive compared with cash bonds, selling of cash JGBs was limited due to the lingering jitters and uncertainty over the U.S. financial system, traders said.

"Selling is limited, reflecting how JGB market players are not fully convinced of the rescue plan and thus are unwilling to make a one-way bet," said Tatsuo Ichikawa, bond strategist at RBS Securities in Tokyo.

The lead 10-year JGB futures contract fell as much as 1.39 point to 138.06, before trimming some losses to 138.73, down 0.72 point.

On Tuesday, futures had finished 2.10 points higher after soaring by their daily limit of 3 points during the day, buoyed by safe haven buying in the wake of the collapse of Lehman Brothers.

The benchmark 10-year JGB yield rose 2.5 basis points to 1.490 percent, moving away from a five-month low of 1.375 percent hit on Tuesday.

"Selling of futures is a natural course as AIG's rescue is good news for stocks, and pushed Treasuries lower," said a trader at a Japanese insurance firm.

The Nikkei rose 1.2 percent.

Reduced incentives for flight-to-quality hit shorter maturities, with two-year yields rising 4 basis points to 0.740 percent and five-year yields rising 3 basis points to 1.070 percent. Both yields fell to five-month lows on Tuesday.

AIG is the latest company to be slammed by the mortgage and credit crisis. Lehman filed for bankruptcy protection and Merrill Lynch & Co agreed to sell itself to Bank of America Corp <BAC.N> this week.

AUCTION EYED

The collapse of Lehman has raised concerns about the outcome of the 20-year JGB auction due on Thursday, as Lehman was among the top bidders at JGB auctions, particularly in the super-long maturities, traders said.

Traders were worried that the absence of a key primary dealer could make securities firms even more cautious about bidding at the auction, leading to a weak result and pushing yields on longer-dated bonds higher.

Securities firms, hit by the financial market turbulence, have become extremely cautious about actively bidding at auctions for fear of being left with bonds they can't sell to investors.

The Ministry of Finance will sell 800 billion yen ($7.60 billion) in 20-year JGBs on Thursday, with market players looking for a 2.1 or 2.2 percent coupon, compared with a 2.1 percent coupon at the maturity's auction last month.

The Bank of Japan kept interest rates unchanged at 0.50 percent on Wednesday as widely expected and maintained its assessment of the economy, which it said was still sluggish. [ID:nT23593]

"It is not as if the BOJ can do much about credit risks in the United States. Its stance will probably be that if there is a shortage of funds (in the money market) it will respond by supplying ample funds," said Akitsugu Bandou, senior economist for Okasan Securities.

While the BOJ was unlikely to lower interest rates, economic conditions do not merit a rate hike either, Bandou said, adding that the BOJ was likely to wait at least until the July-September quarter of next year before raising interest rates.

The BOJ pumped a total of 3 trillion yen into the money market via same-day operations to ease credit jitters as overseas funding costs jumped. The move followed similar injections totalling 2.5 trillion yen on Tuesday and matched a record injection in March.

The Fed kept interest rates unchanged on Tuesday.

($1=105.32 Yen)

(Additional reporting by Masayuki Kitano; Editing by Chris Gallagher)

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