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Geneva, Switzerland

Economics World September 7, 2024

Buying short and selling long – the central bank’s control over the capital market

Photo: AFP

Buying short and selling long, that is, the central bank buys short-term treasury bonds and sells long-term treasury bonds. This method has been used by central banks in many countries to regulate financial markets. This is the first time that China’s central bank has openly bought and sold government bonds, and it has adopted the same strategy. In August, the People’s Bank of China (PBOC) launched an open market treasury bond trading operation, with a net purchase of bonds with a face value of 100 billion yuan. Buying short-term Treasury bonds is intended to inject base money while selling long-term Treasury bonds is intended to block a possible long-term bond bubble and maintain financial stability. “Buy short and sell long” helps to keep the normal upward pattern of the yield curve.

And once the yield curve is straight or even reversed, it means the potential for a financial crisis. An inverted yield curve indicates that long-term interest rates are lower than short-term interest rates. In the case of an inverted yield curve, the lower the yield, the farther the maturity date. The inverted curve, sometimes referred to as a negative yield curve, has proven to be a reliable indicator of recessions in the past.

Generally speaking, long-end interest rates are higher than short-end interest rates. The long-term and short-end inversion refers to the reversal of this situation, the short-end interest rate of one year is higher than the long-end interest rate of the ten-year period, and the market is not optimistic about the long-term economy, and is unwilling to borrow money to do long-term economic expansion, and the economy is in recession.

Recession expectations are formed, everyone wants to quickly exchange assets for cash, flee first, and promote cash to become expensive, which means that short-end interest rates will rise quickly (overnight lending rates will also rise), and even form a liquidity crisis at some point in time, which was the case with the United States subprime mortgage crisis in 2007.

In March 2024, Fed official Waller also suggested buying more short-term Treasuries and adjusting the Fed’s balance sheet through a “buy short and sell long” strategy. The advantage of this is that when short-term Treasuries are not renewed at maturity, the Fed can effectively control the growth of its total balance sheet by avoiding over-buying or holding too many long-term assets while providing market liquidity support.

In addition, increasing holdings of short-term U.S. bonds will also help narrow the inversion of the long-term and short-term U.S. Treasury yield curve, attracting more market funds to flow back to the long-term U.S. bond subscription market. This will support the Fed to implement its balance sheet reduction plan smoothly.

Therefore, buying short and selling long is a means of coordination between monetary policy and fiscal policy, which plays an important role in regulating market operation and maintaining the yield curve. Recently, the United States Treasury inverted yield curve has finally eased, does this mean that the success of United States’ monetary and fiscal policy and the disappearance of the recession shadow? Let’s wait and see.

By Le Tianyu

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