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NEW YORK, April 3 (Reuters) - Expectations the Bank of Japan will unleash sweeping new stimulus measures to dig the country out of decades of deflation has crushed the yen, but its darkest days may be over.
Expectations of aggressive action from the BoJ since late last year may have been overly ambitious, especially with the central bank historically cautious with its policy endeavors, analysts say, adding that the yen's weakness may have gotten ahead of itself.
The dollar has risen 7.2 percent against the yen so far this year and roughly 22 percent since early November. However, dollar/yen hit a one-month low on Tuesday and the options market shows demand remains skewed toward protection against further dollar weakness.
The BoJ, when it concludes its two-day policy meeting on Thursday, is widely expected to announce plans to ramp up its bond buying and extend the maturities of the bonds it purchases under new Governor Haruhiko Kuroda.
However, most analysts contend aggressive action by Japan's central bank is already priced into the yen, and that investors may even be expecting too much. The dollar is down considerably from its three-and-a-half year peak of 96.71 yen reached on March 12, and it has not broken 96 in intraday trading since March 21.
Should any Bank of Japan stimulus proposal fall short of the lofty expectations, that would serve as a surprise for those expecting more yen weakness.
Investors have recently been paring hefty bets in favor of the greenback after a round of soft U.S. economic data called into question the strength of the world's largest economy.
"We are currently neutral on the dollar versus the yen and it has likely hit its peak," said Anjun Zhou, managing director, head of multi-asset research at Mellon Capital in San Francisco.
In the options market, risk reversals, a broad gauge of currency market sentiment, show options investors are seeking protection against a drop in the dollar.
Risk reversals measure the relative demand for options on the dollar rising or falling against the yen.
Three-month risk reversals are biased to puts, the right to sell dollars at a future date. Prior to March they were skewed toward calls, the right to buy dollars.
Yields on benchmark 10-year U.S. Treasury securities have fallen in recent days following weak data from the United States and China, the world's second-largest economy.
Yields differentials between U.S. Treasuries and government bonds in Japan, one of the few major world markets with less attractive yields than the U.S., are a primary driver of dollar/yen price action. The greenback usually falls out of favor against the yen when there is a drop in Treasury yields, which move inversely to prices.
"U.S. data has been weak for 1-2 weeks now, making the link to U.S. yields at the low end of the recent range, which has been a drag on dollar/yen," said Jens Nordvig, global head of FX strategy at Nomura Securities in New York.
"Meanwhile, there is nervousness about the BoJ this week and some worry that expectations are too high," said Nordvig, whose three-month forecast for dollar/yen is at 95.
Implied volatility, or "vol," a measure of expected price swings and a gauge of option pricing, on three-month dollar/yen options traded at 11.188 percent on Wednesday, not far from its 2013 intra-day high on Feb. 6 at 12.738 percent. High volatility implies investors expect more extreme price swings and investors are expected to pay more for an option.
With dollar long positions - bets made on a currency rising - at extremely lofty levels, the scope for further gains has also limited the greenback's upside.
In the week ended March 22, currency speculators increased bets in favor of the dollar to the largest since the week ended July 17, 2012, according to data from the Commodity Futures Trading Commission.
"Front-end risk reversals are reflecting stretched positioning and the fact that a lot is expected out of the BoJ, making it harder for them to surprise to the upside," said John Hopkinson, head of FX quantitative and options research, at BofA Merrill Lynch in New York.