By Junko Fujita and Rocky Swift
TOKYO, March 2 (Reuters) - Market expectations for Japanese bond yields and the central bank's next rate increase have been thrown into disarray as investors fear an extended conflict in the Middle East will have knock-on effects on the yen and domestic inflation.
The initial reaction by Japanese government bonds pointed to diminished expectations for an early move by the central bank. The two-year JGB yield, which is most sensitive to BOJ policy rates, fell 3 basis
points to 1.215% on Monday as the joint strikes by the U.S. and Israel on Iran roiled global markets.
Tehran retaliated with missile barrages after the killing of Supreme Leader Ali Khamenei over the weekend and U.S. President Donald Trump signalled that the assault on Iran could continue for weeks. A drawn-out conflict risks driving up energy prices and weakening the yen, raising the prospect of imported inflation that could complicate the BOJ's policy path.
"The BOJ may have to hurry in raising rates if the conflict continues because rising oil prices would accelerate inflation and the yen may fall," said Hiroshi Namioka, chief strategist at T&D Asset Management. "The BOJ is already behind in raising rates."
The BOJ raised its key rate in December and signalled more increases were on the way as it sought to normalise monetary policy after a massive, decade-long stimulus. Persistent weakness in the yen has caused market expectations for the next move to shift to as early as April from June or July.
On Monday, BOJ Deputy Governor Ryozo Himino said market volatility would not prevent a rate increase but he gave no hints on timing, saying the decision was dependent on the inflation rate stabilising around the central bank's 2% target.
Japan's debt market is not alone in experiencing push-and-pull effects from the Iran crisis. Haven flows may support demand for bonds, while inflation fears could prompt selling as investors price in rate hikes, according to Mizuho Securities chief bond strategist Noriatsu Tanji.
"We believe that the BOJ and other central banks are likely to focus more on rising inflation than deteriorating economic performance - and turn commensurately more hawkish - even if things do start to turn stagflationary," Tanji wrote in a note.
Japanese Prime Minister Sanae Takaichi came to power by promising expanded fiscal stimulus and she is believed to have a dim view of BOJ tightening and its effect on slowing the economy.
Some analysts say an extended Iran crisis would deal a wider blow to Japan's economy than an uptick in inflation, adding to the argument that the BOJ should stand still.
"Since the BOJ views underlying inflation as below 2%, it would prioritize supporting the economy," said Naoya Hasegawa, chief bond strategist at Okasan Securities. "So in that sense, a rate hike in April, seen as a likely scenario among many market players, may be delayed."
(Reporting by Junko Fujita and Rocky Swift; Editing by Thomas Derpinghaus)
