Bank of Japan's response in focus as Japan's 10-year JGB yields hit two-year high

TOKYO (Reuters) - Japan's benchmark 10-year government bond yields rose to their highest in more than two years on Monday, drawing market attention to how the central bank will respond if yields keep creeping away from its 0% target.

The U.S. 10-year Treasury yield rose almost four basis points to a one-year high of 1.3822% during Asian trading hours, reflecting hopes that steady vaccine rollouts and huge fiscal spending will reflate the U.S. economy.

The rise in U.S. yields helped drive up the 10-year Japanese government bond (JGB) yield by 1.5 basis points to 0.115%, the highest since November 2018.

Japanese yields were also underpinned by lingering market speculation the BOJ could widen the 40-basis-point band under which it allows 10-year yields to move around its 0% target.

With 10-year JGB yields having breached the psychologically important 0.1% mark, market players are focusing on whether the BOJ could step in to prevent yields from approaching 0.2%.

The recent rise in Japanese yields could be welcomed by the BOJ, because it wants yields to be driven more by market forces, said Naomi Muguruma, senior market economist at Mitsubishi UFJ Morgan Stanley Securities.

"The BOJ doesn't feel it needs to stop each and every rise in JGB yields, particularly if they are driven by positive economic fundamentals," she said.

The BOJ did not conduct special market operations on Monday, a sign it saw the recent rises as tolerable. But that could change if the rise continues to pace up, analysts said.

"The BOJ needs to step in if it feels that leaving rises unattended could give markets the impression it is tolerating an unacceptable spike in yields," said a source familiar with the central bank's thinking. "That goes regardless of whether the 10-year yield is moving within or beyond the 40-basis band."

Under its policy of yield curve control, the BOJ guides short-term rates at -0.1% and 10-year bond yields around zero.

It has several tools to prevent yields from deviating too much from its target, such as offering to buy bigger amounts or conducting unscheduled market operations.

The last resort, and the strongest weapon, is to conduct a special market operation under which it pledges to buy unlimited amount of bonds at a fixed rate.

The BOJ is probably wary of resorting to that tool unless yield rises become hard to control, because doing so could push yield moves back in an extremely tight range, analysts said.

(Reporting by Leika Kihara and Junko Fujita; additional reporting by Tokyo markets team and Kentaro Sugiyama; editing by Vinay Dwivedi, Larry King)

By Leika Kihara and Junko Fujita