The yen rose toward a 15-year high against the dollar on Wednesday, sending benchmark government bond yields below 1 percent and adding pressure on Japanese policymakers to keep the fragile economic recovery on course.
Finance Minister Yoshihiko Noda reiterated that he is closely watching currency moves as markets speculate whether authorities will consider intervention or if the Bank of Japan might relax its already ultra-loose monetary policy to curb the yen's rise.
Policymakers are worried that the yen's strength could undermine Japanese exports, which have led the economy out of the global downturn, and add to deflationary pressures following 16 straight months of falling consumer prices.
Most currency dealers, however, think official intervention is unlikely before the dollar breaks below the 15-year low of 84.82. The yen rose 0.4 percent on Wednesday to 85.41, taking its gains so far this year to nearly 9 percent.
The ruling Democratic Party also is preoccupied with a divided parliament following its defeat in an upper house election last month, so any response from the government would be limited at best, analysts say.
Bond market players also said they did not expect the BOJ to unveil any new monetary easing steps at a policy meeting next week, unless the yen's gains accelerate alarmingly.
The Democrats have been taking such great pains to stabilize the domestic political situation that they are not in a position to put pressure on the Bank of Japan to stem the yen's rise, at least for now, said Junya Tanase, chief FX strategist for JPMorgan Chase Bank in Tokyo.
Still, further monetary easing would more likely be an option than currency intervention, and government pressure could mount on the BOJ if the yen rises sharply in a single day.
The yen's rise and the slide in 10-year government bond yields largely reflect factors beyond Tokyo's control, complicating the issue for policymakers.
The dollar index <.DXY>, which measures the currency against a basket of other major units, has dropped to its lowest level since April as data points to a faltering U.S. recovery.
The latest fall in bond yields is also being helped by fears that sputtering U.S. growth would weigh on Japan's economy.
A U.S. economic slowdown would hurt emerging markets, which would in turn damage Japanese exports. As such, hopes for an economic recovery at home are being scaled back, also because the yen is appreciating, said Akitsugu Bandou, senior economist at Okasan Securities.
Reflecting conncers about the U.S. and Japanese economies, benchmark 10-year government bond yields slid to 0.995 percent, their lowest since August 2003 and a drop of 41 basis points from a peak in early April.
The dollar fell to around 85.30 yen, its lowest since late November. A fall below a November low of 84.82 yen would take the dollar to its lowest yen value in 15 years.
We're watching closely, Noda told reporters when asked about the exchange rate.
The yen's rise also hit the stock market, with the Nikkei average <.N225> dropping 2.1 percent as exporters' shares fell. Camera maker Canon Inc <7751.T> fell more than 4 percent. <.T>
Japan's economy grew at an annualized rate of 5.0 percent in the first quarter, the fastest pace in the G7 after Canada, but growth is expected to slow during the rest of the year as the pace of exports moderates and some government subsidies expire.
The downturn and stubbornly weak domestic demand have led to 16 straight months of deflation.
Markets in Japan are rife with speculation that the BOJ may ease monetary policy further when its board meets on August 10 if the yen shoots up further.
Analysts believe that a BOJ decision, under government pressure, to set up a bank funding scheme in December was designed to help cool the yen, suggesting further central bank action could be considered.
But the government has kept relatively quiet in recent weeks, even as calls mount from some ruling party members to impose an inflation target on the BOJ, in contrast to last year when the government criticized the bank for not doing enough.
Prime Minister Naoto Kan rebuffed such calls earlier this week, saying Japan needed to overcome deflation but there was no need for an inflation target.
Politics is in a muddle and we don't know who is going to be prime minister after (the ruling party leadership election on) September 14, said Norihiro Fujito, a senior strategist at Mitsubishi UFJ Morgan Stanley Securities.
The chances of a major policy move before then are extremely low.
If the BOJ does ease policy further, analysts expect it to opt for only minor tweaks.
Japanese authorities have not intervened in foreign exchange markets since March 2004, when their 15-month long yen selling spree came to an end. During that period, they sold 35 trillion yen ($408 billion) to curb the yen's strength and support the country's exporting industries.
Japan would also have a hard time convincing their G7 partners about the need for intervention now, when they are pressing China to let its currency appreciate further.
(Additional reporting by Stanley White, Kaori Kaneko, Tetsushi Kajimoto; Editing by Neil Fullick & Kim Coghill)