* Yield drops on expectations that a Kuroda-led BOJ would ease more
* BOJ still has tools to control credit expansion-strategist
By Lisa Twaronite
TOKYO, Feb 25 The yield on the five-year Japanese government bond tumbled to another record low on Monday, and many market participants say further moves down are likely in light of rising expectations for more drastic easing steps from the Bank of Japan.
While long-term rates could eventually rise if the easing shows signs of actually whipping deflation and achieving the BOJ's 2 percent inflation target, short- and medium term rates could remain anchored at rock-bottom levels as long as the central bank remains committed to buying JGBs.
The five-year yield dropped 1 basis point to 0.120 percent, the lowest recorded since Japan started issuing 5-year bonds in 2000, after sources said monetary easing advocate Haruhiko Kuroda will be tapped as the next central bank chief.
The five-year tenor began its push into uncharted record-low territory last month, on expectations the BOJ will eventually increase the time left to maturity of JGBs bought in its asset purchase programme, which now stands at three years.
The central bank is also likely to consider scrapping interest it pays on banks' excess reserves as part of future policy steps aimed at beating deflation. Expectations of this have also pushed down rates in the short- and medium-term sectors.
"Ten basis points is probably the floor for now, but if the new governor decides to cut interest on reserves, then there might be a chance for the five-year to go lower," said Le Ngoc Nhan, a strategist at Morgan Stanley MUFG Securities in Tokyo.
As the BOJ can use the interest on reserves as a tool to control short-term rates as it sees fit, it still has that weapon in its arsenal if the low rates were ever to fuel a credit bubble, Nhan said.
The BOJ can simply raise the interest on reserves and effectively control credit expansion -- and inflation -- no matter how much its balance sheet expands.
"There are some risks out there, but it's not something we should be concerned about in the near term," Nhan said.
"You don't need to shrink the balance. If people can lend to the central bank at a higher rate, they don't need to lend to the private sector."
In the meantime, market participants continued to buy five-year JGBs, even at such low yields, since there is little risk in holding the notes. As long as this is the case, the five-year yield faces a yawning chasm of possibly offering no return to investors.
"Theoretically speaking, it [the five-year yield] could go as low as zero percent," said Naomi Muguruma, senior strategist at Mitsubishi UFJ Morgan Stanley Securities.
She noted that the scenario has changed since the last time five-year yields were at a then-record low of 0.145 percent in June 2003.
That plunge was partly due to hopes that new BOJ governor Toshihiko Fukui would aggressively ease, and it set the stage for a correction back above 1 percent just three months later. A similar sudden spike in yields is much less likely now, with the central bank already buying assets and committed to buying even more.
The BOJ has already pledged to pump 101 trillion yen ($1 trillion) into the economy by the end of this year through its asset purchases and lending programme, and will shift to open-ended purchases from 2014.
"The main tool then [in 2003] was BOJ's lending to the private sector, not the outright JGB purchase," Muguruma said. "This time, the main tool for the BOJ's expansion of the balance sheet is outright JGB purchases, which directly tightens supply/demand conditions in the JGB market."