Japanese manufacturers' business sentiment worsened for the first time in nearly two years this quarter, a Bank of Japan survey showed, as they felt the pinch from a strong yen and slowing overseas growth.

The decline in business confidence was less than expected. But big manufacturers also expect conditions to deteriorate over the next three months, the closely watched tankan survey showed on Wednesday, boding ill for the fragile economy and keeping up pressure on the BOJ to maintain interest rates near zero.

BOJ policymakers are expected to scrutinize the survey at their rate review next week, although the central bank is seen holding off on easing monetary policy further after having taken action in October.

The outlook for big firms and manufacturers felt a little weak, said Yoshiki Shinke, senior economist, Dai-Ichi Life Research Institute.

The BOJ is likely to stick with its current status for a while ... Rather than economic indexes, the trigger (for further easing) is likely to come from the market, such as stocks falling greatly or the yen strengthening even more due to overseas events.

MURKY OUTLOOK

The headline index measuring big manufacturers' sentiment fell to plus 5 from plus 8 in September, marking the first decline in seven quarters. But it was higher than a median market forecast of plus 3.

The index for March next year was seen at minus 2, showing that the murky economic outlook was making companies even more cautious about business conditions in the coming three months.

That may hurt corporate capital spending, which is holding up relatively well for now.

Big firms plan to increase capital spending by 2.9 percent in the year to March 2011, slightly more than a median forecast for a 2.7 percent rise and recovering from a 15.5 percent decline in the year ended in March.

Japan's economy is expected to have contracted slightly in the final quarter of this year on slowing overseas growth and slumping factory output after the September expiry of government incentives for purchases of low-emission cars dented demand.

Analysts expect the country's economic growth to pick up early next year with support from exports to fast-growing Asia, but only modestly.

The BOJ has pledged to keep interest rates effectively at zero until the end of deflation is in sight and rolled out a 5 trillion yen ($60 billion) pool of funds to buy assets ranging from government bonds to corporate debt.

The central bank has said topping up the fund is a strong option if the economy worsens more than expected but it does not want to do so too soon.

The tankan's sentiment indexes are derived by subtracting the percentage of respondents who say conditions are poor from those who say they are good. Positive readings mean optimists outnumber pessimists.

(Editing by Edmund Klamann)

Japan