Yen jumps as markets test BOJ, inflation retreat lifts stocks

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By Dhara Ranasinghe

LONDON (Reuters) - World stocks scaled one-month highs on Friday as hopes of inflation easing took hold, while the yen jumped to seven-month peaks and Japanese bond yields breached a central bank target as investors challenged its commitment to loose monetary policy.

European shares rallied and the broad STOXX 600 index hit its highest since April, while Asian-Pacific shares outside Japan hit a new seven-month high and was headed for a third consecutive week of gains.

U.S. stock futures dipped but sentiment generally was upbeat a day after data showed U.S. price pressures easing further. World stocks were set for the best start to the year in decades.

Graphic: World stocks see stellar start to year https://fingfx.thomsonreuters.com/gfx/mkt/mopakjqdypa/Pasted%20image%201673606397958.png

Japan grabbed the market spotlight as the yen shot up and benchmark 10-year government bond yields briefly breached the BOJ's 0.5% ceiling on speculation that its yield curve control policy could be revised, or even abandoned, as early as next week's policy meeting.

A wave of emergency BOJ buying later reined the yield back in, but markets remained jumpy.

The yen strengthened to 128.11 per dollar -- its highest since late May. It was last up 0.7% and has rallied 6% in little more than three weeks since the BOJ stunned markets by widening the band around its 10-year bond (JGB) yield target.

A newspaper report flagging the possibility of more flexibility has redoubled bets on a coming shift out of ultra-easy policy that seeks to pin yields near zero. The BOJ said it will conduct additional outright bond purchases on Monday, a move that should keep yields in check.

"Japan has been the last bastion of low rates and you shouldn't underestimate that it is a big deal if they change course," said Nordea chief analyst Jan von Gerich.

The BOJ will likely raise its inflation forecasts next week and debate whether further steps are needed, sources familiar with the bank's thinking told Reuters.

INFLATION OPTIMISM

Beyond Japan, market sentiment was dominated by overnight U.S. December inflation data that landed more or less on consensus expectations. The annual pace of headline consumer price rises slowed to 6.5% in December from 7.1% in November.

Investors responded by down-shifting expectations for U.S. interest rates. A Federal Reserve hike of 25 basis points rather than 50 next month is now anticipated, with futures markets pricing in rate cuts later this year.

Against this backdrop, MSCI's World Stock Index rallied to a one-month high and was set for its biggest weekly jump in two months.

"Markets are too optimistic on two points. One is on the inflation trajectory," said Eric Vanraes, a portfolio manager at Eric Sturdza Investments.

"The second point is that equity markets want to believe that there won't be a sharp recession and that's not logical if we think the bond markets are anticipating easing at the end of the year."

U.S. earnings were in focus with JPMorgan Chase & Co (NYSE:JPM), Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C) and Wells Fargo (NYSE:WFC) & Co are forecast to report lower fourth-quarter profits before the opening bell.

The dollar slipped broadly. The euro briefly rallied to a nine-month high of $1.0868 per and the risk-sensitive Australian dollar rose to a roughly five-month high at $0.6994.

The yield on the 10-year U.S. Treasury yield briefly fell to 3.418%, its lowest since Dec 7.

News that Britain's economy unexpectedly eked out some modest growth in November supported sterling, which rallied 0.25% versus the dollar.

Oil meanwhile extended gains, with Brent crude futures were last up around 1% at $84.89. [O/R]

Elsewhere, South Korea's central bank raised its policy interest rate by 25 basis points on Friday, as expected, and economists now think it might have reached the end of its hiking cycle.