By Leika Kihara
TOKYO, May 19 (Reuters) - Financial market turbulence could force the Bank of Japan to go slow on the unwinding of its massive debt holdings, giving anxious bond investors some relief as surging yields lay bare worsening fiscal strains and inflation pressures.
The central bank sets a high bar for outright bond market intervention, said three sources familiar with the BOJ's thinking, but it could flag a slowdown or pause in its so-called quantitative tightening plans for next fiscal
year if conditions demand it.
A reduction in the BOJ's holdings, currently at around 500 trillion yen ($3.14 trillion), has been in train since 2024 under Governor Kazuo Ueda as part of efforts to normalise monetary policy after decades of ultra-low interest rates.
The BOJ is widely expected to lift interest rates at its June 15-16 meeting to curb hot inflation but, in a nod to an increasingly uncertain global environment, might signal a less aggressive tapering of bond purchases.
While no decision has been made yet on the exact pace of tapering, the BOJ sees little need to rush in reducing its huge balance sheet in times of market stress, they said.
"The BOJ's bond holdings have decreased quite a bit, so there could be a case to pause its taper to provide sufficient liquidity," one of the sources said.
"A slowdown or pause in taper won't be ruled out, especially if markets remain jittery," another source said, a view echoed by a third source. The sources spoke on condition of anonymity as they were not authorised to comment publicly.
The BOJ will review its bond taper plan running through March next year and lay out a new plan for fiscal 2027 at the June policy meeting.
The BOJ has collected surveys from bond investors and will hold two-day meetings with them from Thursday to sound out their views on the preferred pace of bond buying. The outcome will have huge sway on its final decision on the taper plan.
The decision will test Ueda's resolve in pushing through a slow but steady withdrawal of a decade-long, massive stimulus that began in 2024.
The BOJ will likely stick to its taper plan through March next year and sees little need for now to conduct emergency bond buying operations - a tool it sets aside to deal with "rapid rises in long-term interest rates," the sources said.
There is little reason to intervene when yields are moving reflecting fundamentals such as investors' views on fiscal and monetary policy, a sign of proper market functioning, they said.
Bond market intervention could also prove costly by exposing the BOJ's line in the sand and force it to defend the level with huge buying, analysts say.
"It's a risky step that could backfire if markets perceive it as debt monetisation," said Katsutoshi Inadome, senior bond strategist at Sumitomo Mitsui Trust Asset Management. "I don't think we're at a stage where the BOJ would intervene."
A SOOTHING SIGNAL FOR THE MARKETS?
The key focus for markets, then, is how the recent bond rout could affect the BOJ's taper plan for fiscal 2027 and onward.
Under a QT programme that began in 2024, the BOJ has been gradually reducing its monthly bond purchases and currently trims monthly buying by around 200 billion yen each quarter.
BOJ watchers see three options on the table: pause the taper and keep buying at the current pace of roughly 2 trillion yen per month, reduce monthly buying by 200 billion yen each quarter, or by a more modest 100 billion yen.
A pause would signal the BOJ's focus on soothing market nerves. Maintaining the current 200-billion-yen per quarter pace would underline its preference to steadily proceed with QT. Seeking a middle ground could result in a slowdown to 100 billion yen per quarter.
"With the bond market so unstable, my bet is that the BOJ will pause tapering," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities. Inadome sees a good chance the BOJ will taper at 100 billion yen per quarter.
For its part, the BOJ has said its QT programme has no implication for short-term rates, the main lever of its monetary policy.
At the same time, the BOJ may pause or slow tapering if it opts to raise short-term rates in June, to avoid giving the impression it was tightening the screws on funding.
The Organization for Economic Co-operation and Development (OECD) last week warned of risks associated with the declining share of JGBs held by banks, insurance firms and pension funds after years of low rates.
The runoff of maturing JGBs each year means the BOJ has seen its bond holdings fall by nearly 20% from a peak around 590 trillion yen in late 2023.
But the BOJ still owns 49% of total JGBs sold in the market, making its every move hugely influential on yields and the cost of funding Japan's huge debt pile.
Highlighting the sensitivity around QT, even hawkish BOJ board member Hajime Takata has warned of fragility in the bond market.
"Since the reduction in purchases in effect supplies the market with JGBs, it's necessary ... to ensure stability and thereby avoid causing excessive volatility," Takata said in February. "If such volatility were to occur, the JGB market may see a deterioration in functioning or become dysfunctional."
($1 = 159.0300 yen)
(Reporting by Leika Kihara; Editing by Sam Holmes)
