By Antoni Slodkowski
TOKYO, March 16 (Reuters) - Japan's Nikkei average rallied 4.4 percent on Wednesday after the worst two-day selloff since the 1987 crash, with some investors scooping up shares even as many fretted that a further deterioration in nuclear crisis could undermine the market.
Gains were mostly driven by hedge funds covering short positions taken in futures during the previous day's plunge, as well as some light buying by some household investors after the two-day plunge of more than 16 percent, traders said.
"The rebound is pretty strong as investors realised they may have panicked a bit too much yesterday," said Fujio Ando, senior managing director at Chibagin Asset Management.
Overall Japanese investors were still skittish after the sharp slide and reluctant to step in, fearing more bad news on the stricken nuclear reactor north of Tokyo could send shares into another tailspin.
"The market doesn't care about any fundamentals today. All eyes are on the nuclear plant and the Nikkei will move according to the news about the plant," said Norihiro Fujito, a senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities. "The market is still extremely volatile." JGB futures slid a half a point and 20-year yields jumped to a one-year high as bond dealers fretted that a long-term bond auction later in the day may have trouble finding buyers. Japanese insurers were selling bonds on Tuesday to cover losses in their stock portfolios.
The yen dropped across the board, with the dollar pushing up to 81.00 yen but still not far from a record low of 79.75 hit against the Japanese currency in 1995.
Market players were also still keeping an eye out for Japanese companies and insurers selling their hefty foreign asset holdings and repatriating funds to cover costs from the nuclear crisis, quake and tsunami, a factor that could drive the yen higher.
So far traders have not seen much fund repatriation, and some cited Japanese life insurers buying the higher-yielding Australian dollar. The Australian dollar jumped nearly 1 percent against the yen.
The Bank of Japan was seen checking rates on currencies with banks in Tokyo, traders said, a warning it could intervene against any further yen strength that would deal another blow to the economy.
"It kind of makes you feel that they are ready to intervene if the dollar falls below 80 yen," said a trader at a Japanese bank.
Japan's finance minister told a meeting with a ruling party lawmaker that he was watching the currency market closely.
The situation at the Fukushima Daiichi nuclear plant 240 km (150 miles) north of Tokyo was still tense. A fire broke out on Wednesday at the plant and sent low levels of radiation wafting into Tokyo, prompting some people to flee the capital.
Some traders say Japanese banks have sold foreign assets to load up on cash in case of big customer withdrawals, while others said the efforts by the Bank of Japan to supply cheap funds reduces the need for repatriation.
Most traders felt it would take Japanese insurers weeks to assess their cash needs before deciding to sell any foreign assets.
The Nikkei was up 4.4 percent at 8,981.14 after having plunged 10.6 percent on Tuesday, still down 12.4 percent from Friday's close. Osaka Nikkei futures were up 3.1 percent at 8,910 but pulled back from an intraday high of 9,070.
The broader TOPIX rose 5.1 percent to 805.90 .
Hedge funds were cited as aggressive sellers of Nikkei futures on Tuesday as the market panicked over reports of leaking radiation from the stricken Fukushima nuclear reactor and higher radiation readings near Tokyo, traders said.
Domestic fund managers have largely stuck to the sidelines, suggesting that they man need to sell into any rebound, traders said. Other fund managers struck a brave face about the crisis and prospects for Japan's biggest companies.
"Many Japanese companies are between 50 and 100 years old and they have been through many shocks and crises, but in their DNA they have ability to pick up the pieces and rebuild. They are competitive in the true meaning of this word. That's why our stance is to invest in such firms, despite of what has happened," said Tetsuro Ii, CEO of Commons Asset Management.
"We want to buy, but we need to have more information about the level of damage at different companies, so we will be gathering this information and invest very carefully," Ii said.
The two-day selloff wiped $626 billion in market capitalisation of the Tokyo Stock Exchange's first section of major shares.
While investors felt the market had tumbled too far unless the crisis takes a much more serious turn for the worse, few were willing to step in just yet.
The Nikkei's 14-day relative strength index, a common technical indicator of whether a market is overbought or oversold, struck a very oversold level of 17 on Tuesday before rising to 27.4 on Wednesday. A reading below 30 suggests a market is oversold.
Laurence Balanco, a technical analyst at CLSA, said that the Nikkei's RSI had only fallen below 17 on eight occasions since 1970, and the market's average return after one week of doing so was 6.22 percent.
Bonds lost more ground. Ten-year JGB futures were down 0.68 point to 139.60 , while the 20-year yield climbed 5 basis points to 2.130 percent and struck a one-year high of 2.150 percent.
Japan's Ministry of Finance will sell 1.1 trillion yen ($13.4 billion) of 20-year bonds later in the day.
Worries that Japan will have to issue more debt to pay for the cost of reconstruction have hit long-term Japanese bond yields and the spreads of Japanese sovereign credit default swaps.