Volatile Bond Market Puts Bank of Japan in a Spin

Tomohiro Ohsumi | Bloomberg | Getty Images

The Bank of Japan (BOJ) is not expected to make significant changes at this week's monetary-policy meeting, although policymakers could use the opportunity to calm fears in the bond market about the implications of the radical stimulus measures unveiled last month.

The benchmark 10-year Japanese government bond (JGBs) yield has doubled since the BOJ said in early April it would pump $1.4 trillion into the economy to meet a 2 percent inflation target in about two years.

While the BOJ hopes that buying up a sizeable chunk of domestic bonds will encourage Japanese investors to buy riskier assets such as equities, the concern is that the massive buying will dry up liquidity in the world's second biggest debt market and make it vulnerable to wild swings.

The other worry is that a sudden, sharp rise in yields could affect the interest payments on Japan's debt, which is estimated to reach 245 percent of gross domestic product this year - the highest in the world.

(Read More: This Is Now the World's Most Volatile Bond Market)

"If you look at the JGB market, the BOJ really is having an awful lot of problems executing its monetary policy," Robert Rennie, global head of foreign exchange strategy at Westpac in Sydney told CNBC Asia's "Squawk Box."

"Yields have surged in the past few weeks and that tells you that something is not working in terms of a domestic point of view," he added.

A Japanese government panel has said there is "no guarantee" that investors at home would keep financing Japan's massive public debt, saying a risk of a spike in bond yields could harm long-term growth prospects, a draft report seen by Reuters showed on Tuesday.

No Crisis

Still, BOJ watchers said Governor Haruhiko Kuroda was likely to sound a positive note on the JGB volatility when the central bank concludes its two-day meeting on Wednesday and was unlikely to tinker with monetary policy just yet.

"Kuroda may put a positive spin on it and say the rise in bond yields is a sign of rising optimism that the BOJ can beat deflation," said Richard Jerram, chief economist at Bank of Singapore.

"They have laid out the map for monetary policy for a while so unless the economy is off track in six months' time, they [BOJ officials] will leave policy alone," he added.

The aim of the monetary easing program is to pump money into the economy in an effort to revive growth and boost consumption.

(Read More: Central Banks in Driving Seat for Asia Markets)

Junko Nishioka, chief Japan economist at Royal Bank of Scotland in Tokyo, said any comments on Wednesday from the BOJ on the sharp decline in yen were another thing to look out for.

The yen has shed about 19 percent against the greenback so far this year, and 4 percent in the past two weeks alone.

"The BOJ may stress the upside risks to the economy and inflation expectations because of the weaker yen," said Nishioka.

"There might also be some focus on anything the BOJ says about the outlook for growth. Economic conditions appear to be improving so it seems its [the BOJ's] optimistic views are becoming more feasible and so it might say it is more confident about meeting its 2 percent inflation target," she added.

Japan's government on Monday upgraded its assessment of the economy for the first time in two months, saying the economy is gradually recovering.

(Read More: Hold On, Japan Still Missing Key Pillar of Growth)

By CNBC.Com's Dhara Ranasinghe; follow her on Twitter @DharaCNBC