TOKYO, Oct 29 (Reuters) - Should the Bank of Japan refrain from easing as strongly as the market expects at a policy review on Tuesday, the yen is likely to recover some lost ground, but futures and options market data suggests the yen's underlying bear trend will remain intact.
The Bank of Japan is widely expected to announce an expansion in its stimulus measures through an increase its asset buying and lending programme by at least 10 trillion yen, mostly via more government bond buying, though the measures could also include an additional small rise in purchases of riskier assets.
But bearishness towards the yen is based on more than expectations over what the central bank might do, with worries mounting over Japan's deteriorating trade balances and fiscal deficit.
"Positions in futures and options show foreign players are more convinced about a weaker yen trend compared to earlier this year or last year," said Takao Hattori, senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo.
Interest in buying dollar options have grown steadily, and dollar/yen risk reversals JPY1MRR=ICAP JPY3MRR=ICAP show a bias for yen puts/dollar calls gaining ground to near highest levels this year.
Expectations for a BOJ easing lifted currency speculators' bets against the yen last week, when the market posted a net short position for the first time since May at some 18,000 contracts.
If the BOJ does less than expected on the easing front, the yen could rally as speculators close these positions, but the recovery is likely to be shortlived.
Hattori reckoned the yen, which stood at around 79.70 to the dollar 0510 GMT on Monday, could recover to 78.80 to the dollar if short covering of the 18,000 contracts was triggered.
Hiroshi Maeba, head of FX trading Japan for UBS in Tokyo, said the scale of a yen recovery would depend on by how much any central bank measures undershot the market's expecations, but he also doubted whether the recovery would have legs.
"I doubt such a yen buying would push the dollar/yen below 79 yen," Maeba said, adding that he didn't expect the dollar to fall to year lows around 76-77 yen.
"What's changed since earlier this year is that yen buying has clearly been shrinking, flows surrounding the yen have changed," he said, noting factors like falling Japanese exports and Asian central banks' failure to boost yen assets.
While the dollar's downside may be limited, Japanese and foreign players are looking to sell the dollar near the 2012 highs around 84 yen, traders and analysts say.
"Foreigners see the yen as overvalued and want a catalyst to sell the yen," said Naohiko Baba, Japan chief economist at Goldman Sachs.
If the BOJ's move matches the most-expected scenario, the yen may ease by 0.3-0.4 yen against the dollar, but if the BOJ eases by less than expected the yen could recover 0.3-0.4 yen, Baba said.
For the dollar to firm to 80-81 yen, the spread between two-year U.S. Treasury and JGB yields would have to widen to 30 basis points from 20 bps currently, Baba said.
And for the dollar to weaken to 78.50 yen, the spread would have to narrow to 15 bps, he added.
Fundamentals, notably Japan's worsening trade position, suggest the yen is likely to move to a weaker trading range, even if the potential shifts in interest rate differentials don't point to a major breakout from current levels.
Japan's trade deficit from January to September was about 4.8 trillion yen, nearly double the deficit of around 2.5 trillion yen for the whole of 2011, Daisuke Karakama, market economist for Mizuho Corporate Bank, wrote in a recent research note.
"The interest rate differentials suggest the dollar/yen is not yet at a structural turning point, but supply/demand balances appear to point to a change," Karakama wrote. "We must brace for an upward shift in the (dollar/yen) range."
