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Central bank group warns institutional investors on forward guidance

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Forward Guidance, the central bank policy providing the market with guidance to its monetary policy, can cause an increased sensitivity in equity and bond markets, affecting pension fund investments, a financial organisation has warned.

The Bank for International Settlements (BIS), an organisation of central banks, provided analysis on the impact of forward guidance in the UK, euro-zone, the US and Japan.

In its analysis, it found that forward guidance increased the sensitivity of financial variables to economic news.

Looking at data from the US, the organisation analysed how differently financial markets responded to news about employment data, a key threshold used by the US Federal Reserve for its rate guidance, in and out of guidance periods.

The BIS said one-year futures rates had become less sensitive to employment surprises, but that the yield on 10-year bonds and equity prices had an increased sensitivity.

In the UK, the two-year futures rates fell by almost 10 basis points when the Bank of England said it was looking at the introduction of forward guidance in the near future.

The European Central Bank’s guidance in July 2013 also had a negative impact on both one-year and two-year futures rates.

However, it is the policy’s impact on securities and bonds, and overall market stability, which would cause the most concern for institutional investors, as its use continues in major markets.

BIS said forward guidance created instability when monetary policy became overly concerned about adverse market reactions to the policy.

This resulted, in the current environment, for monetary policy normalisation to potentially be delayed unnecessarily.

“The mere perception of this possibility, over time, could encourage excessive risk-taking and thereby foster a build-up of financial vulnerabilities,” the BIS warned.

It added: “If financial markets become narrowly focused on certain aspects of a central bank’s forward guidance, a broader interpretation or recalibration of the guidance could lead to disruptive market reactions.”

The BIS cited financial markets’ reassessing the future path of US interest rates in response to tapering communications from the Fed as an example of implicit risks to stability.

“A global bond market sell-off ensued,” the research said, “along with a break in equity markets and a sharp depreciation of some emerging market exchange rates.”

This comes as Aon Hewitt warned that UK schemes were running too much interest-rate risk in their portfolios.

The consultancy said long-term interest rates, one of the biggest financial risks faced by schemes, were significantly under-hedged, by 30-40 percentage points.

John Belgrove, senior partner at the firm, said: “Long-term rates have moved up more than many expected.”

He said, despite short-term rates not moving, the expectation they would rise was implied in the longer term.

The BoE has kept rates at 0.5% for more than five years. However, schemes significantly benefited in 2013 from a rise in future interest rate expectations.

This was in part due to the forward guidance given by BoE governor Mark Carney, when he began to link interest rate decisions to unemployment.

“UK pension schemes are leaving themselves over-exposed to long-term rate changes when compared with many other risks,” Belgrove said. ”Why take such unbalanced risks? Even where pension schemes have taken action, the level of hedge taken is often still sub-optimal, and does not adequately address the issue.”

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