BOJ to Consider Steps to Calm Bond Market

Tomohiro Ohsumi | Bloomberg | Getty Images

The Bank of Japan will consider taking further steps to curb any future spike in bond yields when it debates policy on Tuesday, with the recent market turbulence threatening to derail its radical stimulus plan that relies heavily on boosting confidence to foster sustainable growth and end chronic deflation.

Rising yields have already pushed up some mortgage rates, and there are worries that a further rise in yields could raise other borrowing costs and dent economic momentum.

The BOJ could take the unusual step of extending the duration of its fixed-rate lending to two years, according to sources familiar with its thinking, but there are some in the central bank who do not support such a move.

(Read More: Yen On the Defensive as BOJ Decision Looms)

The extension would make it easier for banks that were caught wrong-footed by last month's spike in yields to hedge their portfolios, which would reduce their need to sell bonds, thus potentially dampening market swings and reducing upward pressure on yields.

While the bond market has restored some calm, analysts say the BOJ is keen to guard against a renewed spike in bond yields that could threaten the central bank's objective of achieving 2 percent inflation in roughly two years.

"I'm not sure how much effect it will have on yields. But it will at least send a message to markets that the BOJ is mindful of curbing volatility in the bond market," said Yasuo Yamamoto, senior economist at Mizuho Research Institute in Tokyo.

"If the yen spikes again, the BOJ may ease again. But with markets relatively stable, it's likely to stand pat on monetary policy for now."

The BOJ, which stunned financial markets on April 4 by setting in motion the world's most intense burst of monetary stimulus, is widely expected to keep its policy settings unchanged at the two-day rate review ending on Tuesday.

Instead, it is hoping that fine-tuning its market operations will be sufficient to stem market turbulence for now.

Market Tumult

The Nikkei share average briefly slumped into bear market territory on Friday after a punishing 2-1/2-week sell off that saw the benchmark drop over 20 percent since May 23 and wipe out $500 billion of market capitalization.

The market mood was soured by the rising bond yields, slowing growth in China and uncertainty over when the U.S.

Federal Reserve would roll back its stimulus.

The yen also surged to a two-month high against the dollar last week, weighing on the export-reliant economy and taking back a chunk of the feel-good effect of "Abenomics," a policy prescription of sweeping fiscal and monetary expansion aimed at jolting the world's third-biggest economy from a two-decade long slump.

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Before the setback, market euphoria over the government's campaign to reflate the economy drove Japanese equities up over 70 percent since mid-November and sent the yen tumbling to a 4-1/2-year low against the dollar to 103.74 yen last month.

A loss of market confidence would be a big blow to Abenomics, which relies on sentiment to spur a virtuous circle of consumption, investment, higher wages and lending to revitalize the economy.

Some market players speculate that the BOJ could top up its target for purchases of risk assets as early as on Tuesday, in the wake of the sharp falls in Tokyo share prices.

But many in the central bank prefer to leave its government debt and risk asset purchases unchanged, with no clear evidence that the recent market turbulence is undermining prospects for a steady economic recovery.

(Read More: An End in Sight for Japan's Turbulent Markets?)

The longest period for which the central bank offers funds in fixed-rate market operations is currently one year.

Central bankers are entertaining the idea of expanding that to two years, for the first time ever, after some banks suggested this could be more effective at a recent meeting with the BOJ, the sources said.

The BOJ's nine board members are expected to discuss the idea on Tuesday, although it may result in a split vote as not all of them feel the need to act so quickly.

Some central bankers are hesitant about going that far as it would give much greater authority to bureaucrats who conduct day-to-day market operations. It would also effectively mean the

BOJ is committed to keeping interest rates at 0.1 percent for two years, binding its hands on future monetary policy.

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"If there is demand in the market for such funds that is something the BOJ would consider, but even the one-year funding operation is rare for the BOJ," said one source familiar with the central bank's thinking.

In an unusual decision, the BOJ offered 1.5 trillion yen ($15 billion) of funds at a fixed rate of 0.1 percent in April in a move that temporarily slowed a rise in yields.

Benchmark 10-year bond yields have been stable in a 0.8 percent to 0.9 percent range in the past week, pulling back from a 13-month high of 1.0 percent hit on May 23.

The BOJ pledged in April to double its bond holdings in two years to expand the supply of money at an annual pace of 60 trillion to 70 trillion yen to meet its pledge of achieving the 2 inflation target.

Markets are focusing on what BOJ Governor Haruhiko Kuroda has to say in his post-meeting news conference on the bond market turbulence, which has cast doubt on his argument that the April action would help push down yields across the curve.