Fed taper to test demand for Treasuries When it comes to losing money this year, investors could barely have done worse than buying long-term Treasury debt, which has seen a double-digit percentage loss. Now, their stomachs are set for a further test, as the US Treasury seeks buyers of long-term paper, albeit at the highest yields since August of 2011 and a full percentage point above their auction levels in May. The scale of demand for the latest slug of Treasury issuance will go a long way to determining whether the bond market has priced in the prospect of less easing from the Federal Reserve, which has been buying $45bn of government bonds per month so far this year. Any reluctance to own Treasuries at their current levels, on the part of investors would suggest yields, which move inversely to prices, have further room to rise. That would likely trouble policy makers, who have sought to curb the rise in bond yields in recent weeks as it has driven up the cost of borrowing for new and prospective homeowners and is seen potentially weighing on the broad economy's recovery. One bullish indicator is that when the 10-year note yield hit a peak of 2.75 per cent last month, strong buying emerged. "We did see hand over fist buying at that level in July," says William O'Donnell, strategist at RBS Securities. The important considerations for bond investors is how much speed the US economy gains in the coming months and how that ultimately influences Fed policy. The danger is that the speed of the Fed's Taper could accelerate as economic data picks up and the unemployment rate drops, further pressuring bond prices. Michael Kastner, principal at Halyard Asset Management says there is a risk that bond yields rise further as economic growth for the second quarter and the July jobs number is revised upwards. It looks like the economy has underlying strength and as an investor you have to respect the bond selling we saw in May and June when the taper was introduced by the Fed. The climb in rates since the prior auction cycle in May, means the new 30-year bond will arrive with a fixed coupon of 3.75 per cent, versus its current coupon of 2.875 per cent. The downside of such a yield move is that the Barclays Treasury index with a maturity of more than 20 years, has already registered a total return of minus 11 per cent since January. But higher bond coupons are seen appealing to long-term investors such as insurance companies and life insurers, who need to match long-term liabilities with income streams that run for decades. Another factor favouring Treasuries is that Washington has yet to tackle its budget and funding issues, and investors still recall how in August of 2011 political gridlock nearly triggered a technical debt default by the US and sparked a big rally in government bond prices. The five-year point is much more sensitive to the timing of the Fed withdrawing its support than the 30-year bond Zach Pandl, interest rate strategist at Columbia Asset Management Thierry Wizman, global interest rate strategist at Macquarie says: "While we believe in the US recovery there is the risk of a fiscal battle in Congress and we could see a game of chicken start playing out that helps Treasuries as people sell risky assets." Mr Kastner says caution over Treasuries is warranted, in spite of much higher yields since May. Buying the 30-year around 3.75 per cent may appeal to some investors, but there is a risk that its yield rises to 4 per cent and that's a meaningful hit to a portfolio. In general, bond traders expect buyers will support the market around current levels, with the pronounced rise in yields in recent months seen as a buying opportunity when the US Treasury sells $24bn 10-year notes on Wednesday, followed by a $16bn offering of 30-year bonds on Thursday. "Interest rates are now more closely tied to the performance of the economy and what that ultimately means for Fed policy," says Zach Pandl, interest rate strategist at Columbia Asset Management. We think quantitative easing works mainly through expectations and yields have risen because as the market anticipates the Fed will start tapering bond purchases. Anshul Pradhan, strategist at Barclays says Fed tapering is largely reflected by higher 30-year bond yields and that holders of Treasuries with a maturity of five, to 10-years are more vulnerable to losses in the future. This is based on Barclays expecting the unemployment rate falling faster than current consensus expectations, which in turn pulls the timing of rate hikes forward. For now the market is pricing in a very low funds rate into 2016 and Mr Pradhan says the risk is that monetary tightening occurs faster as the labour market surprises to the upside of expectations. Such an outcome would largely hurt shorter dated Treasuries, and help long-term Treasuries prosper, a key trading strategy, known as playing the yield curve in the bond market. While bond yields would rise further, long-dated Treasuries would lag the climb. "The easy trade of being underweight interest rate risk is largely done, now we will see how the yield curve evolves with changing expectations for Fed policy," says Mr Pandl. The five-year point is much more sensitive to the timing of the Fed withdrawing its support than the 30-year bond.