June 2012 Special Report on Bonds, FREE - Elliott Wave International

© <strong>June</strong> 6, <strong>2012</strong> 

Written by Prechter, Hochberg and Kendall 

<strong>Special</strong> <strong>Report</strong> 

major top in the bond market: 

BOND YIELDS ARE POISED TO BEGIN RISING 

ON THE WAY TO DEFLATIONARY CREDIT CRISIS 

U.S Treasury Bonds 

Our long term outlook for interest rates on U.S. Treasury securities has been a contrary opinion for 

many years. Most commentators have been expecting either economic expansion or Fed-induced inflation 

to push bond yields higher. Conquer the Crash predicted that long term rates on AAA-rated bonds would 

fall much further as the monetary environment shifted from lessening inflation to outright deflation. Figure 

1 shows the forecast from 2002, and Figure 2 updates the graph to the present. 

Figure 1 

Figure 2 

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Elliott Wave <strong>Special</strong> <strong>Report</strong>—<strong>June</strong> 6, <strong>2012</strong> 

In line with our forecast, the interest rate on the Treasury’s 10-year note has just plunged to the lowest 

level in U.S. history. The decline from 1981 to the present is a stunning 91%. Figure 3 shows a close-up of 

the entire move. 

Those predicting economic expansion or hyperinflation have been unable to explain this persistent 

plunge. Yet each of these camps got exactly the “fundamentals” they expected: record monetization by the 

Fed (advocated by the monetarists) and record spending by government (advocated by the Keynesians). 

Rates ignored these events and continued to fall. 

For the past ten years, many high-profile investors have hated bonds. When interviewed, they would 

say that the one sure bet was that rates would rise and bond prices would fall. Those betting against bonds 

have lost a lot of money, especially since 2009. 

Under the Elliott wave model, five-wave patterns occur in the direction of the main trend, and countertrend 

moves trace out three-wave patterns. Interest rates do not follow the Elliott wave model as well as stock 

averages, which are more responsive to overall social mood. Rates are the price of just one thing: money. But 

it is still interesting to see how many five-wave patterns unfolded in the same direction as the long decline 

over the past 31 years, as labeled in Figure 3. 

Figure 3 

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In the Great Depression, interest rates on lower-grade bonds trended lower until 1930, and those on 

high-grade bonds continued lower until 1931. Then they soared, on fears of default. Figure 4, published in 

Conquer the Crash, shows what happened. (The chart shows rates inverted to reflect bond prices.) 

During the Great Depression, bond prices finally bottomed, and interest rates peaked, in <strong>June</strong> 1932 (see 

Figure 4); stocks bottomed in July; and those years’ only freely traded (semi-)monetary metal, silver, bottomed 

in December. Following expectations under socionomic theory, the economy bottomed afterward, in the first 

quarter of 1933. If the same sequence occurs again, rates should peak first, stock prices should bottom next, 

and individual commodities should make lows throughout the period, with some of them bottoming last. 

Finally the economy will hit bottom. 

The preceding peak rate of inflation in that cycle occurred in late 1919/early 1920, so the time between 

the extremes was just shy of 13 years. In the current cycle, the grand change from the maximum rate of 

inflation to a maximum rate of deflation seems to be on track to consume approximately a Fibonacci 34 

years (+ or – 1 year). From as far back as 2001, using several time-forecasting approaches, EWT has forecast 

that the final stock market bottom would occur in 2016. This timing suggests a peak rate of deflation in 

Figure 4 

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or near 2015, a bit ahead of the low in 

stocks. Although we tentatively expect the 

bottoming sequence to take place between 

2015 and 2017, the sequence per se is more 

certain than its timing. 

One might think that interest rates will 

therefore fall until around 2016. But they 

won’t. The reason is that borrowers are going 

to default. 

Investors think that the issuers of all 

the bonds they are buying will stay solvent 

and pay both interest and principal. We 

don’t think so. We think the economy is still 

sliding into depression, and when that trend 

accelerates, investors’ waxing fears will 

cause them to start selling bonds, which will 

lead to lower bond prices and higher yields. 

Investor psychology should work 

like this: As positive social mood initially 

retreats, investors looking for a haven buy 

bonds that they perceive to be safe. But 

as social mood continues to trend toward 

the negative, fear increases, deflation 

accelerates, the incomes of businesses and 

governments decline, and bond investors 

begin to worry about losing their principal 

due to bankruptcy and default by bond 

issuers. That’s when they start selling bonds, 

and rates begin to rise. Rates on the weakest 

issues rise first, but eventually fear spreads 

to holders even of formerly presumed safe 

paper. Finally, the economy contracts so 

severely that it reaches depression, wiping 

Figure 5 

out many debtors and, in the process, many creditors as well. 

In the current cycle, low-grade bond yields have yet to begin climbing. As shown in Figure 5 (again with 

the scale inverted), yields for the Baa group have been moving lower right along with those for Treasuries. 

Commentators are saying that investors’ sustained move into bonds is a sign of fear. But in line with continued 

predictions of a “sustained but slow economic recovery,” bond buyers have reached a state of epic complacency 

in the belief that all of these bonds are safe. As we will see in Figure 9, the spread between rates on T-bonds 

and Baa corporates has been quietly widening for nearly a year. This is a subtle warning of trouble ahead 

for the high-yield sector. At this point, we still cannot place “peak” arrows on Figure 5 as there are on the 

1930s version in Figure 4. But we should be able to do so soon. 

Figure 6 shows the history of the Bond Buyer index of 40 corporate bonds during the Great Depression. 

Figure 7 shows the history of its modern equivalent, the Bond Buyer 20-bond index. Bond prices today seem 

poised to do what their predecessors did: plunge. 

In early 1932, prices on these bonds fell below—and rates rose above—those registered at the preceding 

peak rate of inflation in 1920. This is a good reason to expect interest rates on these bonds in coming years 

to rise above those of 1981, i.e. above 16%. 

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Figure 6 

Figure 7 

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The question is, when will rates begin rising in this cycle? We think the answer is “now.” Evidence is 

rapidly mounting that the trend in interest rates on high-grade debt is poised to reverse: 

1. As shown in Figure 3, the latest drop in yield has traced out five waves into Friday’s new low as bond 

futures hit a new all-time high of 152½. This plunge in rates should mark at least a bottom and probably 

the bottom. 

2. The public has been buying a lot of U.S. government bonds since 2002, as shown in Figure 8. Investors 

stayed enamored of government bond funds in 2011 while selling into the stock rally. The public loved 

real estate at the top; it loved stocks at the top; it loved commodities at the top; it loved silver at the 

top; and it loved gold at the top. What do you think it means now that the public is heavily invested in 

U.S. government bonds? 

3. The Commitment of Traders report shows that Large Speculators have become heavily invested in 

T-bond futures (see Figure 9). Large Specs are not always wrong, but they are usually wrong when 

they follow a trend. The asterisks in Figure 9 show times when their buying or selling was in concert 

with the trend, and in those cases the market was approaching a reversal. 

4. According to the Daily Sentiment Index (courtesy trade-futures.com), there were 97% bulls among 

futures traders on Friday. This is the third-highest reading on record. (It reached 99% in December 

2008, at the spike high in T-bonds following Fed’s pledge to buy them.) The DSI reached 90% bulls in 

<strong>June</strong> 2011, and except for a brief period in January-March it has been near the 90% level for much of 

the past year. This is both an extreme level and a lengthy period of bullish sentiment. 

5. T-bonds have enjoyed their longest and biggest bull market on record. There are no guarantees in life 

or investing, but we are pretty sure that buying an extended market after three decades of rise is not 

a good idea. Regardless of whether our monetary and economic expectations turn out right, the bull 

market in bonds is aged and ripe for reversal. 

If rates do begin to rise as we expect, most observers will probably be fooled. Bulls on the economy may 

take the new trend as a sign of economic expansion. Those betting on hyperinflation may take it as a sign 

that inflation is ready to soar. But the real reason for the coming rise in rates will be that investors will be 

Figure 8 

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Figure 9 

selling bonds and demanding higher rates due to fear of default. We have seen this development already in 

the debt paper of Greece and other weak debtors. It should soon seep over to the stronger debtors. 

You might think that the U.S. government is the strongest sovereign debtor. It isn’t. Eight other 

governments pay lower rates on their 10-year notes. The U.S. 10-year yield hit a low of 1.438% on Friday, 

its lowest level ever. But the yields on comparable bonds elsewhere are lower: Singapore 1.37%, Taiwan and 

Germany 1.17%, Sweden 1.11%, Denmark 0.93%, Hong Kong 0.88%, Japan 0.80% and Switzerland 0.47%. 

The coming fear of default will not be misplaced. With a turn of Grand Supercycle degree behind us, the 

unfolding depression will be deeper than that of the early 1930s. Most debtors around the world will default. 

The Coming Yield-Spread Explosion 

In January 2005, two months before the spread between the 30-year U.S. Treasury bond yield and the 

Moody’s Corporate Baa bond yield reached its narrowest extreme in years, EWFF said, “Typically, such 

complacency [toward riskier assets] is a precursor to a large and persistent move” in the opposite direction. 

By the end of March, the spread between low-grade and high-grade debt yields had begun to widen. EWFF 

that month called for a move to record wide levels. In the last quarter of 2008, the widest spread since the 

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inception of 30-year Treasuries 

in the 1970s was achieved in 

conjunction with Primary wave 

1 down in stocks. Figure 10 

shows this event. 

Like so many financial 

assets, high yield bonds rose 

in 2009-2010 as stocks rallied 

in wave 2. In January 2011, 

EWFF noted that bond fund 

managers were aggressively 

citing an improved risk 

environment and touting junk 

bonds as a reliable place to grab 

a little extra yield. We countered 

with the following assessment: 

The perceived lack of 

alternatives is creating 

what may be the costliest 

mistake in the history of 

investments—reaching 

for yield at the onset of a 

depression. When near-term manifestations 

of mood turn back toward increasing 

pessimism, this spread should widen to a 

historic extreme. 

Figure 10 

The narrowing between rates on low- and 

high-grade debt reached its extreme in July 

2011, three months after the tops in the 

NYSE Composite stock index, the CRB 

Commodities index, foreign currencies and 

silver. As Figure 10 shows, the spread made 

a lower high in early April <strong>2012</strong>, coinciding 

with the highs in the Dow, S&P and NASDAQ. 

It is now on the verge of widening past its 

October 4, 2011 level. The recent <strong>June</strong> issue 

of EWFF reiterated that a move toward record 

widening remains the bedrock of our bond 

market forecast. During Primary 3 down 

in stocks, the spread between low-grade and 

high-grade debt should exceed the extreme 

reached in late 2008. 

The recent spike in high-yield mutual 

fund inflows (per the bottom graph in Figure 

11) shows that investors continued to reach 

for yield through the final rally in stocks. 

It’s been said that junk bonds are simply 

equities in drag since they are the riskiest 

class of debt securities, and this chart bears 

that label out. It sports tops in 1989, which is Figure 11 

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close to a major peak in the Dow Transports; 

April 1999, three months ahead of the peak 

in the Real-Money Dow (Dow/gold); and 

May 2007, just two months before the Dow 

Jones Composite average topped and five 

months before stocks started plunging. That 

bear market led to credit spreads reaching the 

record levels shown in Figure 10. 

Per Figure 11, however, the collapse 

failed to drive total assets in high-yield 

bond funds beneath their low of July 2002, 

no doubt because investors were (and still 

are) perceiving all grades of bonds as their 

new safe haven. From that time forward, 

total assets in high-yield bond funds more 

than doubled and continued to expand right 

through April <strong>2012</strong>, our last available data 

point. The evidence presented in recent issues 

Figure 12 

of EWT and EWFF indicates that stocks 

completed an important peak in May, 

so total junk bond assets should turn 

lower in a coincident reversal, just as 

they have at past equity reversals. The 

five-wave rally pattern, shown by the 

labels in Figure 11, fits our case that 

the impending downturn will be bigger 

than any of the declines over the last 30 

years. In the not-too-distant future, junk 

will finally live up to its name. 

Figure 12 shows the relentless, 

8-fold rise in total bond fund assets over 

the past 22 years. It is a stunning picture, 

reminiscent of the 18-year rise in stocks 

from 1982 to 2000. The sharpest rally to 

date began in October 2008, as investors 

sought an alternative to stocks. We 

expect wave 3 to destroy the belief in 

all havens except cash. 

The long rise in retail demand for 

higher-yielding bond funds supports 

our case for a historic retreat from 

risky debt. According to the Investment 

Company Institute’s long-term-bond 

fund data, which go back to 1984, 

investors became increasingly fond of 

more speculative bonds versus U.S. 

non-mortgage, federal government 

bonds over the course of the bull market. 

Figure 13 shows the ratio of total assets Figure 13 

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in riskier funds holding corporate, high yield and mortgage debt to assets in non-mortgage, federal government 

bond funds. In the 1990s, with the mania for equities at its most intense, investors’ preference for riskier 

bonds rose persistently. An initial high in the ratio came in February 2000, one month after the Dow’s peak 

and a month before the NASDAQ’s all-time high. A decline followed, reaching a low in March 2003, when 

the World Stock Index bottomed. The ratio’s ensuing rise ended in May 2007, as the accompanying rally 

in stocks neared its endpoint. The most recent rise started in December 2008, three months before the start 

of the latest advance in stocks. It ended a year ago, with the assets of riskier bond funds reaching a record 

4.7 times those held in less-risky government-bond funds in <strong>June</strong> 2011. So, after faithfully reflecting the 

general direction of the stock market through <strong>June</strong> 2011, the ratio has failed to approach last year’s peak. 

This is a key divergence from the pattern of events over the course of the Grand Supercycle topping process 

(see charts, May <strong>2012</strong> EWT) and another sign of the exhaustion that’s been overtaking the financial markets 

since May 2011. (For a full description, see this month’s EWFF.) The ratio will undoubtedly continue to 

head in its new direction. This does not mean, however, that government bond prices will continue to rally. 

The unfolding deflation will be murder on the debt of companies and governments alike. But most corporate 

and mortgage bonds will perform worse than Treasury bonds, so investors are likely to shift their preference 

from the former to the latter. 

During the coming collapse in the value of debt, investors’ interest in diversified funds of all stripes— 

debt, equity and commodity—will fall precipitously. The drop will come as a shock, especially to those who 

“rebalanced” from stocks and commodities to bonds after the markets panicked in 2008. 

What To Do 

Generally speaking, if you are invested in long-term debt, sell it. Avoid high-yield bonds like the 

plague. Stay away from most municipal, corporate, government agency and now even Treasury bonds. A 

select few entities will be able to generate the necessary cash flow to defy an otherwise universal rise in 

yields. Discerning them will be difficult. Good candidates seem to be the governments of Switzerland and 

Singapore, the State of Nebraska and Microsoft Corp., but we are not complacent about any of them. If you 

have substantial assets in long term Treasuries and want to keep them, one good strategy would be to sell 

short an offsetting amount of junk bonds, thereby aligning your portfolio for a continued widening of the 

spread between the two. If you wish to hold any unhedged debt, make it short term debt. T-bill rates have 

been stuck near zero, but if rates overall begin to rise, bondholders will lose money while bill holders will 

benefit by rolling continually into higher and higher yields. At the end, the U.S. government might default, 

so do not consider this a permanent strategy. It’s only a last debt-based strategy until the ultimate crisis. We 

have already recommended substantial holdings of outright cash. But at some point, it will be time to convert 

even the safest debt instruments to cash and/or gold. 

The Elliott Wave Theorist and The Elliott Wave Financial Forecast are published by Elliott Wave International, 

Inc. Mail: P.O. Box 1618, Gainesville, Georgia, 30503, U.S.A. Phone: 770-536-0309. All 

contents copyright ©<strong>2012</strong> Elliott Wave International, Inc. Reproduction, retransmission or redistribution 

in any form is illegal and strictly forbidden, as is continuous and regular dissemination of specific forecasts 

or strategies. Otherwise, feel free to quote, cite or review if full credit is given. Typos and other such 

errors are corrected in the online version, which is the official final version of each issue. 

The Elliott Wave Principle is a detailed description of how financial markets behave. The description reveals that mass psychology swings from pessimism 

to optimism and back in a natural sequence, creating specific Elliott wave patterns in price movements. Each pattern has implications regarding the position 

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June 2012 Special Report on Bonds, FREE - Elliott Wave International

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