Big Japanese firms remained upbeat about business conditions in June, a Bank of Japan survey showed on Monday, underscoring the view that the central bank may raise rates as early as August but will stick to a gradual pace of credit tightening.

The yen fell to a session low of 123.28 to the dollar after the BOJ's closely watched quarterly tankan survey came out largely in line with forecasts, compared with around 123.05 just before it was released. Japanese government bond futures hit a three-week high of 132.20, up 0.19 point.

The June tankan, or short-term economic outlook, came after Friday's soft reading on core consumer prices in the Tokyo area, which had boosted expectations for the BOJ to raise rates only gradually and dispelled talk of a rate hike this month.

Ultimately I don't think this is going to change the BOJ's basic stance, said Hiroshi Shiraishi, an economist at Lehman Brothers Japan.

They will see this report as suggesting that decent economic growth is continuing and a gradual tightening will be necessary, although there's nothing really here to suggest the economy is overheating.

The tankan showed a headline diffusion index (DI) for big manufacturers' sentiment of plus 23, matching the market's median forecast and unchanged from the previous survey in March.

The DI for big non-manufacturers stood at plus 22 for June, also matching the consensus forecast and unchanged from March.

Chief Cabinet Secretary Yasuhisa Shiozaki, Japan's top government spokesman, said the tankan confirmed that the Japanese economy was steadily expanding.

But economists voiced concerns about a soft reading for small firms, which were seen having difficulties in passing on rising costs such as higher raw materials prices to their customers.

The DI for small- and mid-sized manufacturers came to plus six, slightly below the consensus forecast of plus seven, while the small non-manufacturers index stood at minus seven as expected.

The weakness in small firms' sentiment suggests future growth may be polarised, says Mari Iwashita, fixed income strategist at Daiwa Securities SMBC.

Market players have been eagerly awaiting the June tankan for clues on whether the BOJ will raise rates to a 12-year high of 0.75 percent in August, as widely expected by markets.

Many analysts expect the BOJ board to keep policy settings unchanged at its meeting on July 11-12.

CAPEX SLOWING

Traders were also focusing on capital spending plans by Japanese firms in gauging the strength of the corporate sector, a key driver of the world's second-largest economy, which is experiencing its longest growth cycle in the post-war era.

The tankan showed big firms expect their capital spending to rise 7.7 percent in the current fiscal year ending next March.

That was short of the market's median forecast for an 8.8 percent rise but was revised up from the 2.9 percent increase seen in the previous survey.

The growth in corporate profits and capex is slowing from last year. But considering their strength last year, that is not surprising and there's no reason to be too pessimistic about the economy, said Taro Saito, senior economist at NLI Research.

The yen's weakness will also help. Companies are assuming a higher yen for this financial year. So if the yen stays at current levels, that will probably boost their earnings.

The tankan showed that big manufacturers see the dollar averaging 114.40 yen in the current business year to next March, compared with 114.32 yen shown in the March tankan survey.

Big manufacturers' outlook index for September was seen at plus 22, showing that they expect business conditions to worsen slightly over the next three months.

The outlook DI for big non-manufacturers stood at plus 23.

The diffusion index is calculated by subtracting the percentage of companies that consider conditions to be unfavourable from those that see them as favourable. A positive number means optimists outnumber pessimists.

The survey covered 10,839 companies, of which 2,469 were categorised as large. It was conducted from May 28 to June 29.

The central bank has kept interest rates on hold after raising the key policy rate to 0.5 percent in February, which was the first rate hike since July last year. (Additional reporting by Leika Kihara and Yoko Nishikawa)

Japan Bank of Japan