Trading of Japanese government bonds has increased since the central bank moved away from controlling yields last month, and at least one indicator in the market suggests that liquidity is returning.

The situation is still far from normal, with the Bank of Japan owning more than half of the ¥1.097 quadrillion ($7.2 trillion) of outstanding securities in the market after years of asset purchases. Gov. Kazuo Ueda has indicated debt buying will be dialed back at some point, and this is necessary given that the central bank’s own survey shows the need for more market participants and increased trading.

Among the signs of progress, the average bid-ask spread to trade the country’s debt has tightened to the narrowest in at least six months, a sign there are plenty of traders wanting to buy or sell the notes.

"I expect the BOJ to gradually back off in the bond market,” said Ayako Sera, a market strategist at Sumitomo Mitsui Trust Bank in Tokyo. "But it has to walk a fine line between improving market liquidity and not causing unnecessary confusion” with a big cut to debt buying, she said.

Overnight-indexed swaps suggest the BOJ will raise its policy rate to 0.2% by the year-end from a current range of zero to 0.1%. Prospects for rises in bond yields may draw local investors who have been seeking higher returns outside the country.

The trading volume of Japanese government bonds has also been trending higher, adding to signs that a once moribund debt market is coming back to life.

Some market indicators still signal concern that the market distortions won’t be quickly cleared away. These include a Bloomberg gauge measuring how much government bond yields are deviating from their model-estimated value, which has risen from a December low.

A BOJ survey of bond market participants showed their perception of market functioning — a synonym for liquidity — has improved from a trough in February 2023, but remains below zero, a level indicating a functional market.

"There are those in the market who believe that the BOJ should reduce the bond-purchase amounts in operations,” said Keisuke Tsuruta, a senior fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo. "They believe it’s buying too much compared with the amount of issuance, which is hurting the functioning of the market.”