Japanese manufacturers turned more pessimistic about their outlook for the first time in almost two years this quarter in a sign that a strong yen could derail the economic recovery and spur the central bank to ease policy next week.
The Bank of Japan tankan survey for the three months to September showed big firms planned to raise capital spending at slower pace than expected as a recovery in exports slows due to a strong yen and slackening overseas demand.
The headline sentiment index improved to 8 from 1 in June, exceeding the median market forecast of 6. But the index is seen sliding to minus 1 in December, showing firms expect conditions to worsen over the next three months and that pessimists outnumber optimists.
This was the first time big manufacturers expected the outlook to worsen since December 2008.
The BOJ has struggled to agree whether it should further relax policy at the Oct. 4-5 meeting, but firms' cautious views and subdued spending plans could tip the balance in favor of those calling for more easing.
Japan's government intervened earlier this month to weaken the yen, and some economists say additional monetary easing is needed to ensure that intervention succeeds in shielding the economy from a strong currency.
"The BOJ was really focused on corporate sentiment and the yen strength is an obvious factor. They'll be under greater pressure to ease from the government ... at the meeting next week," said Naomi Fink, Japan strategist at Bank of Tokyo-Mitsubishi UFJ.
PRESSURE TO EASE
The lead 10-year Japanese government bond futures rose to a seven-year high on increased prospects for BOJ easing, including a possible boost in bond purchases, while the Nikkei stock average climbed 0.6 percent.
The yen largely took the tankan in stride, however, trading at 83.87 yen to the dollar, little changed from just before the data's release.
Japan sold the yen in the market on Sept. 15 for the first time in more than six years after its currency surged to a 15-year high against the dollar.
The September tankan survey was conducted from Aug. 23 to Sept. 28, but it did not capture the impact of intervention because 70 to 80 percent of firms responded by the preliminary deadline on Sept. 7, the central bank said.
Big manufacturers' sentiment gauge in September improved for a sixth straight quarter to its highest since March 2008, while big service-sector firms' confidence was the highest since June 2008.
However, big firms' plan to increase capital spending by 2.4 percent in the financial year to March 2011 came below the market's median forecast for a 4.2 percent rise and the survey did little to ease concerns about a strong yen.
Big manufacturers expect the dollar to average 89.66 yen in the fiscal year that started in April, which may be overly optimistic.
"The expected exchange rate is still above current levels, so foreign exchange could pose downside risks to the corporate outlook," said Yasuo Yamamoto, senior economist at Mizuho Research Institute in Tokyo.
"The BOJ is likely to extend the duration of its funding operations, and a return to zero interest rates is also possible."
Sources have told Reuters that the BOJ could loosen policy if the recovery is deemed by the board to be under threat, with an increase in government bond buying and a further boost to its cheap fund-supply tool emerging as the most likely options.
Still, some BOJ officials have indicated that they want to wait until there is further evidence that the strong yen and slowing overseas growth are hurting the economy.
The BOJ may also be reluctant to pursue aggressive easing because its decision could end up having limited impact if the Federal Reserve eases policy at its next rate review on Nov. 2-3, causing the yen to appreciate further against the dollar.
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