News this week suggesting Japan's $1.26 trillion public pension fund could shift more money into stocks and risky assets overseas should bolster the Nikkei stock index and underpin yen weakness, analysts say.
Advisors to the Government Pension Investment Fund (GPIF), the world's biggest pension fund, said on Thursday the fund does not need to stick to the safety of Japanese government bonds (JGBs).
Analysts say this is a clear sign that the GPIF, which has the potential to have a significant market impact because of its size, could move more funds out of bonds. They add the main implications are that first, more GPIF funds move into equities and then into higher-yielding assets overseas, keeping the yen weak.
"There have been some rumblings about changes to the GPIF for a while but these comments are the most tangible," said Sean Callow, senior currency strategist at Westpac Bank in Sydney.
"It would make sense that they [the GPIF] would look to take on more risk in an environment that the bank of Japan (BOJ) is committed to buying JGBs, driving out other buyers. The first move is likely to be into higher-yielding domestic assets such as equities as there is no currency risk," he added.
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Japanese bonds accounted for about 55 percent of the GPIF portfolioat the end of December, according to data from the pension fund. That's down from almost 65 percent at the end of June 2012. The fund held17 percent of its assets in local shares at the end of December, up from almost 12 percent in June 2012, suggesting a gradual shift away from bonds.
Anticipation of changes at the GPIF may help explain recent market moves. The Nikkei hit a five-week high on Friday, while the yen held near a five-week low of about 103.15 per dollar.
"The yen has been under pressure of late, mainly due to improving risk sentiment and as investors' expectations of the Government Pension Investment Fund considering foreign bond investments rose," analysts at Credit Agricole said in a note.
"According to the Government Advisory Panel the fund does not need to focus on domestic bonds given rising inflation. Such expectations combined with a good chance of risk sentiment improving further should make a case of the yen remaining subject to downside risk," they added.
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Japan's Prime Minister Shinzo Abe has been pressing the GPIF to buy more stocks and invest less in less risky bonds to generate higher returns for an aging population.
His economic policies, often referred to as Abenomics, helped push the yen down more than 20 percent against the dollar last year and boosted Japanese stocks almost 60 percent.
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Still, the public pension fund has been slow to put its weight behind the moves, reflecting in part cautiousness by Japanese institutions.
Analysts say the GPIF was also probably waiting to assess the impact of the BOJ's hefty bond-buying on the market. The BOJ's monetary stimulus plan, which began almost a year ago, led to some market turbulence with 10-year JGB yields spiking to as high as 0.975 percent last May before falling back.
The benchmark 10-year JGB yield was trading at 0.63 percent on Friday.
Now that the BOJ has pretty much established its position as a firm buyer of JGBs, there's enough confidence to suggest the pension funds could go in search of higher returns elsewhere," said Vishnu Varathan, market economist at Mizuho Corporate Bank.
"Many of these institutions are getting behind Abe because they see his policies as a way. They also have their own interests too –to get higher rates to fulfill their liabilities that are coming due sooner rather than later," he added.
— By CNBC.Com's Dhara Ranasinghe; Follow her on Twitter @DharaCNBC