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Bank of Japan Governor Haruhiko Kuroda.TORU HANAI/Reuters

Japanese asset markets finished the session more or less where they started but Friday's gut-wrenching intraday volatility will prevent regional investors from sleeping soundly over the weekend. Mixed signals from the government on inflation expectations are at the heart of market confusion.

Intense volatility continued in Japanese markets Friday. The Nikkei equity benchmark dropped 3.2 per cent after the market open, then rallied back by 4.5 per cent into positive territory before the close. Bond and futures prices were similarly choppy.

Inflation fears, reflected in bonds, appear to be at the centre of Japanese market volatility. On Thursday and Friday, big moves in bond yields preceded selloffs in equities. The biggest, most surprising market event of the week was the difference between Wednesday's close in the 10-year bond yield (0.88 per cent) and the opening yield on Thursday – 0.99 per cent – which set the stage for the market plunge later in the day (see Bloomberg chart at left).

There is notable confusion as to the government's intentions on inflation and interest rates. Bloomberg reports that Bank of Japan chief Haruhiko Kuroda has made comments suggesting both higher and lower rates. "Kuroda said that gains in yields could be expected as the economy improved, after saying previously that the central bank aimed to lower interest rates. The next day, 10-year government bond yields reached the highest level in a year," according to the news service.

The government is buying equities and bonds in the open market as part of a strategy to increase inflation expectations, which in turn would increase demand for loans and spending. On the one hand, buying bonds helps increase the money supply – which is inflationary and suggests higher interest rates and bond yields will lie ahead – but, on the other hand, pushes yields lower. Hence the confusion that is roiling all asset markets.

Mr. Kuroda has pledged to adjust the buying program in bond markets to stabilize interest rates. His emphasis on the point supports the contention that bond markets are driving equity activity. If he can manage to stabilize bond yields, the economic optimism that pushed the Nikkei higher by 80 per cent since November can continue. Stability in the bond markets will provide the best indicator of what lies ahead for Japanese stocks.

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