Confidence among big Japanese manufacturers fell to a five-year low in June, a central bank survey showed, but the fall was less than expected, hitting Japanese bonds while helping push up shares.
Capital spending plans by companies were the weakest in six years for a June survey, but again not as bad as economists had expected in the wake of the U.S. credit crunch and resulting slowdown in some key Japanese export markets.
Japanese shares rose about 0.5 percent while Japanese government bond prices tumbled, as derivative contracts priced in a larger chance of a rate hike by the Bank of Japan (BOJ).
"The key thing shown in the tankan is that the Japanese economy is slowing but not at as rapid a pace as expected," said Takahide Kiuchi, chief economist at Nomura Securities.
"The pace of worsening in business sentiment is moderating and it looks unlikely that the economy is heading toward a deep adjustment," he added.
The headline index for big manufacturers' sentiment dropped to plus 5 from plus 11 in the previous survey in March, a tad above the market's median forecast of plus 3.
It has fallen for three straight quarters and was the lowest since September 2003, when it was plus 1.
The index for September was seen at plus 4, showing firms expect conditions to worsen a bit more over the next three months.
The index is calculated from the percentage of firms reporting a favorable business environment minus those reporting unfavorable conditions.
The Japanese yen ticked up about 0.1 percent on the data to around 106.10 per dollar after the data.
Swap contracts are pricing in 33 percent chance of a rate hike in the second half of this year, compared to about 25 percent late on Monday.
The Japanese economy has been hit by a double whammy of rising energy and raw materials costs and a slowdown in exports in the wake of the credit crisis.
The BOJ has made it clear -- especially since Masaaki Shirakawa took the helm as Governor in April -- that it is more concerned about downside economic risks now, even as other major central banks worry increasingly about inflation.
While the BOJ has said the Japanese economy will slow down only temporarily before returning to a moderate growth path later this year, it has also stressed that uncertainty is large because of lingering concerns over the health of Western banks.
The BOJ is also worried that soaring oil and food prices are eating into Japanese corporate profits and hurting consumer sentiment, rather than fueling broader inflation.
Analysts say Japan's relatively low inflation levels also give the bank some leeway in dealing with inflation.
Japan's core annual consumer inflation hit a decade-high 1.5 percent in May, but it is still well below that of other major industrialized nations.
The tankan showed big firms planned to increase capital capital spending -- a key engine for Japan's growth -- by 2.4 percent in the year to March next year, slightly above the median market forecast from economists for a 2.0 percent rise.
However, companies slashed their profit outlook. Big companies expect their recurring profits to fall 7.0 percent in the financial year to March 2009, compared to their forecast of 0.3 percent rise three months ago.