© June 6, 2012

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Special Report

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

Written by Prechter, Hochberg and Kendall

Elliott Wave Special Report—June 6, 2012

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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 June 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

Elliott Wave Special Report—June 6, 2012

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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
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%.

Figure 5

Elliott Wave Special Report—June 6, 2012

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Figure 7

Figure 6

Elliott Wave Special Report—June 6, 2012

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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
June 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

Elliott Wave Special Report—June 6, 2012

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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

Figure 9

Elliott Wave Special Report—June 6, 2012

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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.

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 2012, 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 June 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

Figure 10

Elliott Wave Special Report—June 6, 2012

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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 2012, our last available data
point. The evidence presented in recent issues
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

Figure 12

Elliott Wave Special Report—June 6, 2012

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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 June 2011. So, after faithfully reflecting the
general direction of the stock market through June 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 2012 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.