By Leika Kihara and Yoshifumi Takemoto

TOKYO (Reuters) – The Bank of Japan’s resolve to defend its yield cap is under attack from investors betting the central bank could cave to global market forces, opening up a slim chance for a short-term policy adjustment.

While few expect the bank to change its yield curve control (YCC) policy on Friday, which guides the yield on 10-year Japanese government bonds (JGBs) around 0%, the sharp declines of the yen are making some lawmakers anxious.

The declines were partly due to the central bank’s aggressive efforts to defend an implied cap of 0.25% for the yield target.

Five government officials and sources familiar with the central bank’s thinking say the key to its Friday decision could be how much the yen is sinking from current 24-year lows to pose a risk large enough to justify monetary policy response.

“Central banks don’t target exchange rates to guide policy,” one of the sources said. “But the yen has fallen at such a rapid pace that it’s hurting the economy, which deserves attention.”

A second source echoed this view.

“We hope the BOJ will take some kind of action at Friday’s meeting,” a government official told Reuters, speaking on condition of anonymity.

“It’s hard to think the BOJ won’t do anything when the US Federal Reserve could raise rates by 75 basis points.”

Prime Minister Fumio Kishida said monetary policy not only affects currency movements but also small and medium businesses through the cost of borrowing.

“While currency movement is a huge issue, I expect the BOJ to consider various effects,” Kishida told a news conference, when asked if the central bank should adjust its policy on Friday.

Prospects for aggressive U.S. interest rate hikes have pushed up long-term interest rates around the world, including in Japan, forcing the BOJ to step up bond buying to defend its upper limit. yield.

“DEFY THE BOJ”

The BOJ spent about 3 trillion yen ($22 billion) buying bonds on Tuesday, followed by additional buying on the yield curve on Wednesday to defend its 0.25% cap.

Despite this, 10-year JGB futures plunged to levels not seen in 2014, following selling by speculators betting that the bank will be forced to adjust its YCC policy.

“The JGB futures market collapsed and there was a big gap between the futures prices and the actual JGB yield,” said Kentaro Koyama, chief economist for Japan at Deutsche Bank.

“Usually some kind of arbitration action could resolve this disparity. But this type of arbitration action does not work well – mainly due to the intervention of the BOJ.”

In theory, the BOJ can buy bonds indefinitely to defend the ceiling with the money it prints, but that would accelerate the fall in the yen which inflates the cost of imports and hurts the economy.

Markets expect the Fed to make a 75 basis point hike at the Federal Open Market Committee (FOMC) meeting later Wednesday, which could accelerate the yen’s slide and increase pressure on the BOJ .

“I remain concerned that the Bank of Japan’s policy meeting is an underestimated point of risk this week, perhaps even more so than the FOMC outcome itself,” said Jeffrey Halley, senior analyst at the Bank of Japan. markets for Asia-Pacific at OANDA.

A very hawkish outlook from the Fed would lift the dollar/yen again and could force the BOJ to raise the 10-year yield cap slightly, he added.

Admittedly, there is little reason for the BOJ to change the YCC now, with much lower inflation than in Western countries and a fragile economy still in need of monetary support.

Veteran BOJ watcher Naomi Muguruma expects the BOJ to hold firm on Friday but said the bank could raise its yield cap to 0.50% from 0.25% if the government asks for help to stop the sharp falls of the yen.

Such an increase in the yield cap would be accompanied by government intervention to buy yen.

“This is a risk scenario in case the fall in the yen continues, and it is clear that these measures are hurting business and household sentiment,” she said.

($1 = 134.7100 yen)

(Reporting by Leika Kihara and Yoshifumi Takemoto; Additional reporting by Tokyo Politics Team and Tom Westbrook; Editing by Clarence Fernandez)

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