The recent spike in U.S. bond yields, coinciding with a rally in the dollar against the yen, is flagging a return to the yen to fund carry trades -- the risky strategy of using a low-yielding currency to purchase assets in higher-yielding currencies in the search for better returns.

The rise in U.S. bond yields is making the cost of carry in the dollar more expensive, which should prompt investors to use the yen -- offering lower rates and less volatility -- to wade back into speculative assets.

I think the yen will reclaim its status as the funding currency of choice in 2010. Even if the Federal Reserve raises rates by 25-50 basis points, that would mean U.S. rates will still be markedly above Japan's, said Richard Franulovich, senior currency strategist at Westpac in New York.

The yen, with its near-zero percent interest rates, was the preferred funding currency for more than seven years. That changed in the summer of 2009 when the cost of benchmark three-month interbank dollar funds fell below that of the yen.

As carry trades depend both on low interest rates and low volatility, the rise in U.S. yields has boosted uncertainty in that market. At the start of December, the credit market started to advance the expected timing of a U.S. interest-rate increase, which caused rate differentials to move in favor of the United States versus Japan.

Although financial markets on Friday pared back U.S. rate hike expectations following an unexpectedly weak U.S. non-farm payrolls report for December, the jobs data did not shake overall optimism about the U.S. economy.

In contrast, deflation remains a major concern in Japan and this means monetary policy will remain on hold and Japanese interest rates will remain at extremely low levels, said Jonathan Clark, deputy chief investment officer at FX Concepts, a $12 billion currency hedge fund in New York.

BACK-UP IN U.S. YIELDS

The dollar/yen pair has become more sensitive to movements in bond yields because the currencies are competing as the markets' favored funding unit. Any shift in the yield curve or rate expectations has an impact on both currencies.

Over the past month, U.S. 10-year bond yields rose from 3.2 percent to 3.92 percent by end-December. The rise in yields has underpinned the dollar, which has surged about 9 percent against the yen since late November.

That was driven mainly by implied inflation expectations, analysts said, and rising spreads in credit default swaps, which suggest nervousness in financial markets has eased and risk appetite has increased.

Short-term U.S. interest rates are likely to remain low. That should leave the market dealing with an extremely steep yield curve, which is attractive to buyers of debt. The difference between the U.S. two-year and 10-year yields was near a record on Friday, at about 286 basis points.

The 25-day correlation between dollar/yen and benchmark U.S. yields was still at a robust 92 percent on Friday, according to Reuters data. It was as high as 94 percent toward the end of last year.

On a 90-day rolling basis, the correlation showed a rising trend.

For a graphic on the dollar/yen correlation with the 10-year yield, click link.reuters.com/cyx32h

JAPAN'S LIFERS

The steeper yield curve in the United States should encourage Japan's life insurance companies, massive but conservative overseas investors known as lifers, to buy the greenback against the yen. Lifers invest heavily in the U.S. Treasury market.

Sebastian Galy, senior currency strategist at BNP Paribas in New York, said the life insurance companies need to have profitable portfolios, adding that their threshold level in yields is around 2 percent.

When they see that the U.S. yield curve is steepening like this...they buy into it, meaning they buy more dollars via U.S. Treasuries because they want to grab yield, he said.

Galy said most Treasury purchases are underhedged, meaning there is no corresponding yen purchase to offset the dollar buying. That suggests these lifers expect the yen to weaken further and the dollar to gain some more, a vied shared by most market participants.

On Friday, the yen fell to its lowest against the dollar since August. Some investors believe the yen has begun a sustained downtrend that could last into the middle of 2010.

Westpac's Franulovich expects dollar/yen to hit 95 in three months and 100 in six months.

(Editing by Leslie Adler)