Lower yield on U.S. Treasuries hampers BOJ effort to rein in yen

The Bank of Japan, struggling to keep the strengthening yen from derailing efforts to repair the economy, is facing a new challenge — the shrinking yield gap between two-year sovereigns and Treasuries.

The extra yield that two-year Treasuries offer over similar-maturity Japanese notes fell Tuesday to the least since 1992.

BOJ Gov. Masaaki Shirakawa said Aug. 4 that there is a "relatively high" correlation between that rate gap and the dollar-yen rate, as falling yield premiums in the U.S. dampen dollar-buying demand from Japanese investors.

The BOJ may need to lengthen the maturity of bonds in its asset purchase program to stop the yen's appreciation, according to Mizuho Securities Co. The BOJ, whose policy rate is already near zero, bolstered stimulus by ¥10 trillion on Aug. 4, the same day Japan intervened in the currency market for the first time since March.

"It's significant that Gov. Shirakawa discussed the Japan-U.S. interest rate gap, and specifically the two-year term, at a time when the yen is strengthening," said Naomi Hasegawa, a senior bond strategist at Mitsubishi UFJ Morgan Stanley Securities Co.

The difference between the U.S. and Japanese two-year yields narrowed to a 19-year low of 3.7 basis points Tuesday.

U.S. two-year Treasury note yields dropped to a record low of 0.1568 percent after the Fed pledged Aug. 9 to keep its benchmark interest rate at an all-time low at least through mid-2013 to aid the economy's recovery. It was at 0.1869 percent Tuesday, while Japanese two-year notes yielded 0.15 percent, according to Bloomberg data.

The BOJ could increase the remaining maturity of government bonds it buys under its asset-purchase program to between two to three years from up to two years now, said Yasunari Ueno, chief market economist at Mizuho Securities.

It could also lower the 0.1 percent rate the BOJ pays banks for keeping funds in its accounts, encouraging them to invest and lend more, he said.

Buying longer bonds would be in line with the recommendations of the International Monetary Fund, which last month said the central bank could "ward off deflation risks and support the recovery" by increasing purchases of government bonds with maturities of three years or more.

The BOJ raised by ¥5 trillion a fund to buy assets such as government debt, corporate bonds and real estate investment trusts, while also boosting by the same amount on Aug. 4 a program to encourage banks to lend. Two-thirds of the ¥15 trillion asset-buying program is earmarked for buying Japanese government debt.

In expanding its stimulus measures this month, the BOJ said there is "high uncertainty" surrounding the economic outlook. Companies cut production and consumers held off from making purchases after March 11.

The economy shrank at a 1.3 percent annual pace in the three months through June, the third-straight quarter of declines, the Cabinet Office said Monday. It will probably rebound in the second half, according to a Bloomberg survey.

A climbing yen is an additional risk for Japan's export-dependent recovery. The yen strengthened to as much as 76.31 per dollar on Thursday, near the postwar high of 76.25 in March that prompted the Group of Seven nations to jointly sell yen.

"There's a limit to how much the two-year rate could fall if the BOJ continues to pay a 0.1 percent interest on deposits, since banks may keep their money in the BOJ account, said Mizuho Securities' Ueno.

Still, reflecting the continued decrease in short-term market rates, the spread between the BOJ's target of unsecured overnight call rates and three-month euroyen futures narrowed to a nine-month low of 20 basis points from a peak of 31.5 basis points in December.

The yield on Japan's benchmark 10-year bond was little changed at 1.035 percent Tuesday.

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