TOKYO, July 28 (Reuters) - Japan's benchmark government bond yield topped the Bank of Japan's ceiling for the first time in more than four months on Friday, while the yen also climbed and equities fell on heightened speculation of an imminent tweak to monetary policy.
The 10-year JGB yield rose 7 basis points (bps) to 0.505%, its highest since March 3, before last trading at 0.500%, the BOJ's cap under its yield curve control (YCC).
The yen strengthened as far as 138.725 per dollar for the first time since July 18, extending overnight gains following a report in the Nikkei newspaper policymakers will discuss allowing long-term interest rates to rise above its YCC ceiling under certain circumstances during its two-day meeting that ends later on Friday.
The time for the policy announcement is not set, but it generally comes after the stock market enter the midday recess at 0230 GMT.
The Nikkei share average declined 1.26% as of 0200 GMT, under pressure from the stronger currency. Of its 225 components, 207 fell, while 17 rose and one was flat.
However, banking stocks rallied to an eight-year peak as the prospect of a steeper yield curve boosted the outlook for lending profit.
Under the new idea to be proposed at the meeting, the BOJ would maintain the 0.5% cap but allow the 10-year yield to rise above that level depending on market developments, according to the Nikkei newspaper.
"If the BOJ were to do as the Nikkei reports, it would essentially be eliminating the yield cap," said Naoya Hasegawa, senior bond strategist at Okasan Securities.
Under YCC, the BOJ guides the 10-year bond yield around 0% and sets an allowance band of 0.5% above and below that target.
"Whether this move would be the first step to tweak or abolish the yield curve control policy, or just an adjustment to continue the framework would depend on the BOJ's economic outlook to be disclosed later in the day," said Takeshi Ishida, strategist at Resona Holdings.
Japan's two-year yield also rose, reaching -0.025% for the first time since April 4. The 30-year yield added 5.5 bps to 1.36%.
Investors had been positioning for a potential policy shift in the currency and debt derivatives market, after the BOJ made short selling more difficult in February by increasing the minimum fee for borrowing some bonds.
The trade already carried the moniker "widow maker" for the potentially crushing losses it could trigger on a policy disappointment.
The options market benchmark for expectations of JGB volatility has nearly tripled to 9.6% in the past three weeks, as investors cottoned on to the idea that - even though second-guessing BOJ policy decisions could be risky - there was less to lose from betting on a volatile market reaction one way or the other.
The yen has been another favoured destination for speculation, driving the currency to a multi-week high at 137.245 per dollar mid-month, form a nearly eight month trough beyond 145 just two weeks earlier.
"We don't short the JGB market. In part, it's an expensive thing to do," Jim Leaviss, chief investment officer for public fixed income at M&G Investments, told the Reuters Global Markets Forum earlier this month.
"We like the yen."
(Reporting by Kevin Buckland; Additional reporting by Junko Fujita, Leika Kihara and Divya Chowdhury Editing by Shri Navaratnam)
