Market Strife Puts Japan Policies in a Flux

Yuriko Nakao | Bloomberg | Getty Images

Japan's radical plans to get the world's third largest economy back on track, which have created investor euphoria in recent months, seem to be losing momentum just as quickly as markets succumb to a triple whammy impact of plunging stocks, a strengthening yen and a volatile bond market.

The yen firmed against a broadly-weak dollar overnight to its highest level in almost a month, moving to the stronger side of the key 100-mark. The benchmark Nikkei on Tuesday meanwhile hit its lowest level since mid-April, extending its decline from last month's 5-1/2 year peak to about 18 percent.

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"There's a lot of volatility domestically, including the fact that JGBs (Japanese government bonds) have been sold off aggressively in recent months," said Robert Rennie, global head of foreign exchange strategy at Westpac Bank. "The Nikkei is under pressure, Japanese investors continue to sell foreign assets and that tells us Japan's monetary policy, at least for the moment, is not working and that's a reason to be cautious."

The Bank of Japan (BOJ) on April 4 moved into unprecedented territory when it said it would pump $1.4 trillion into the economy in less than two years to reflate Japan's economy, which has suffered from two decades of deflation.

And the implication of that aggressive monetary stimulus is a weaker yen, which would underpin exporters and a rally in stocks, which in turn would boost the outlook for a frail economy.

Yet the yen has strengthened about 4 percent in the past two weeks alone against the dollar. And the Nikkei's sharp decline, which analysts say has largely been driven by profit-taking on this year's double-digit gains, is getting closer to levels where it traded before the BOJ fired its "bazooka."

"The Nikkei could potentially be in deeper trouble," Ed Ponsi, managing director at Barchetta Capital Management in New York told CNBC Asia's "Squawk Box."

"This is more than just a pull-back, it's a pretty violent sell-off. I think this all relates to potential tapering from the BOJ because the support from the IMF [International Monetary Fund] for a weaker yen and perhaps elsewhere is beginning to crack," he said.

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The IMF in its annual country report on Japan published on Friday said that while Japan's radical economic policies have got off to a "strong start," considerable risks to the outlook remained.

Japan's government on Wednesday is expected to unveil a long-term growth strategy, which analysts say is key to the success of Prime Minister Shinzo Abe's economic policies, also known as "Abenomics."

According to press reports on Tuesday, the government is also set to urge the country's public pension funds to increase their investment in equities and foreign assets.

Analysts say that although the BOJ's monetary policy has hit a stumbling block near term amid volatile Japanese markets, the central bank was likely to be successful longer-term.

"The BOJ is in uncharted territory and conducting a grand experiment," said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch, talking about Japanese bond yields that have spiked in recent weeks amid uncertainty about what the BOJ's bond-buying plan means for the market.

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"The interim period of volatility is to be expected in a big shift – and that's what Japan is experiencing right now. The same happened to with the Federal Reserve [when it introduced quantitative easing] and that's what the BOJ is going through now and I think it will eventually pull through," he added.

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