[TOKYO] Bond buyers are already testing the credibility of the Bank of Japan's new monetary policy framework, pushing 10-year yields below its zero percent target and giving the bank few palatable options to bring them back on track.
After failing in its goal of achieving sustained inflation, the BOJ last week shifted its primary policy tool away from expanding the money supply and towards controlling the 'yield curve' - making sure long-term rates remain sufficiently above currently negative short-term rates so banks can make a profit from lending into Japan's stagnant economy.
As part of that policy, it pledged to keep the 10-year bond yield - the benchmark banks use to set mortgage and corporate lending rates - at "current levels around zero percent".
The market had other ideas, pushing 10-year bond yields to minus 0.09 per cent this week, putting pressure on the BOJ to take action to bring them back towards its target.
One such action - reducing the BOJ's own massive bond purchases - would bring into question a key plank of the stimulus policy it has been following since 2013 and could have a much more unsettling effect on markets.
The bank knows markets might interpret any cut in bond purchases as casting doubt on its commitment to maintain its money-printing stimulus until inflation overshoots its 2 per cent target. That could trigger a yen spike and hit Tokyo stock prices, while also hurting consumer price expectations and investor confidence more broadly.
BOJ officials remain sanguine for now, saying the zero percent pledge is not so rigid. "It's not a fixed peg but rather a 'managed float'," said one of the officials.
The BOJ has used an aggressive bond buying programme, which runs at 80 trillion yen ($790 billion) a year, to keep rates down to help the fragile economy, and officials said they would not rule out buying fewer, or even selling bonds, to prevent yields from falling too much.
But not everyone is convinced that would work.
"The BOJ can prevent interest rates from rising by printing money to an unlimited extent. But there's doubt whether the BOJ can keep them from falling by reducing bond buying," said Noriatsu Tanji, senior bond strategist at Mizuho Securities.
"Pegging would not work as soon as the BOJ gave up on reducing bond purchases," he said.
Aware of the dilemma, the market is now testing the central bank. While the 10-year yield briefly turned positive at 0.005 per cent when the BOJ announced the policy, traders pushed it as low as minus 0.09 per cent on Wednesday - barely above the minus 0.1 per cent target the bank sets for short-term rates. It stood at minus 0.085 per cent on Thursday.
Financial institutions are confused about the BOJ's intentions and what it can really achieve.
"Is it really possible to guide long-term rates at a set level with market operations? Is it appropriate for a central bank to be doing this in the first place?" said a senior official at one of Japan's biggest insurance firms, voicing concern at the market distortions inherent in excessive intervention.
Some investors say the BOJ will not allow the 10-year yield to fall below the minus 0.1 per cent short-term policy rate target, given it does not want the yield curve to flatten.
But sources familiar with the BOJ's thinking say it does not necessarily see the 0.1 per cent negative yield as a floor for long-term rates as long as yields curve in the right direction.
With the two-year bond yielding minus 0.29 per cent and the five-year yield at minus 0.23 per cent, there is no strong reason to set a minus 0.1 per cent floor for 10-year yields, they said.
In judging whether any yield falls are excessive, the BOJ would look at volatility, yield levels and how long such levels were likely to persist, the sources said.
"If yields fall below what's acceptable, the BOJ will act,"one of the sources said, adding that reducing bond buying would be considered.
Former US Federal Reserve Chairman Ben Bernanke has warned of the difficulty of pegging long-term rates.
"Notably, in defending a peg, a central bank gives up control over the size of its balance sheet, committing to buy whatever supply of bonds is forthcoming at the target rate," Mr Bernanke wrote in a blog on Sept 21.
"In the extreme case, a central bank trying to hold down yields could find itself owning most or all of the eligible securities."
Though Governor Haruhiko Kuroda has voiced confidence the BOJ can control the yield curve, bank bureaucrats say they are learning as they go on.
Much of the work will involve delicate communication with markets on the technicalities of the BOJ's market operations, a turnaround from the simple communication Mr Kuroda preferred in deploying his massive stimulus programme.
"It's challenging," said another source familiar with the BOJ's thinking. "It will be trial and error."