TOKYO (Reuters) - The Bank of Japan will consider taking further steps next week to curb volatility in the government bond market, sources said, as sudden spikes in yields threaten to undermine the bank's objective to drag the economy out of two decades of deflation.
Rising yields have already pushed up some mortgage rates, and there are worries that more market turbulence could lead to a further rise in yields, increasing other borrowing costs and slowing economic momentum.
The BOJ could take the unusual step of extending the duration of its fixed-rate lending to two years, but there are some in the BOJ who do not support such a move.
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.
"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.
The BOJ's nine board members could discuss the idea as early as its next meeting on June 10-11 as it monitors market moves. Turbulence in the bond market has shown signs of easing, but there is still a risk that yields could rise again.
The BOJ is expected to leave its government debt and risk asset purchases unchanged and may also consider a slight upgrade to its economic assessment as exports and industrial production improve.
The longest period for which the central bank offers funds in fixed-rate market operations is currently one year.
In an unusual move, the BOJ offered 1.5 trillion yen ($15.11 billion) of funds at a fixed rate of 0.1 percent in April in a move that temporarily slowed a rise in yields.
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 meeting with the BOJ last week, the sources said.
The extra funds could help prevent the situation where a sudden fall in bond prices causes investors to sell even more bonds to avoid taking losses. Bond prices move in the opposite direction of yields.
Some banks could even use the extra funds to increase their government debt holdings.
For now, the BOJ feels it can soothe bond market jitters through minor adjustments to its debt-purchasing program that were announced last week, such as buying bonds more often each month to spread out the purchases.
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 reached on May 23.
If bond market turbulence resumes, the central bank is ready to take further steps to keep bond yield rises in check, including offering two-year funds at a fixed rate of 0.1 percent in market operations, the sources said.
Effectively, the BOJ would be lending banks money at cheap rates that they can use to hedge their portfolio or even go out and buy more JGBs (again tamping down yields) and earning money on the spread.
However, there are obstacles to this option.
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.
Others within the BOJ say it would be better to promote the central bank's scheme that allows it to supply banks with cheap funds for up to three years provided that the banks increase their lending.
The BOJ also is likely to consider upgrading its economic assessment at its meeting next week, sources say, as exports show signs of recovering and gains in industrial production pick up pace.
Last month, the central bank said the economy has started picking up. If the BOJ upgrades its assessment at its next meeting, that would mark the sixth consecutive month of upgrades.
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 2 percent inflation in roughly two years.
BOJ Governor Haruhiko Kuroda had said the policy was aimed at pushing yields down across the curve. ($1 = 99.2600 Japanese yen)
(Additional reporting by Yoshifumi Takemoto and Sumio Ito; Editing by Kim Coghill)
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