JPMorgan’s Jamie Dimon Sees Bond Market Crack — Why And What To Do

Topline

A bond market crack could destabilize markets. Here’s why it might happen and how to protect your portfolio

Key Facts

Fears of out-of-control U.S. national debt drove JPMorgan CEO Jamie Dimon to predict a bond market crack, according to the Wall Street Journal. “You are going to see a crack in the bond market, OK?” Dimon said during a May 30 interview at the Reagan National Economic Forum in California. “It is going to happen.”

Dimon’s prediction raises many questions:

• What is a bond market crack and why does Dimon think one is coming?
• Will Dimon’s prediction come true?
• Can investors protect their portfolios from a bond market crack?

Here are some quick answers. A bond market crack means bond prices plunge — prompting a surge in demand for liquidity that overwhelms banks’ ability to supply it.

In defense of his prediction — which he said could happen in the next six months or six years, Dimon cited the $2.7 trillion addition to the U.S. budget deficit predicted by 2035 if the recently passed House tax legislation becomes law, noted the Journal.

Dimon could be right. By adding to the $36 trillion national debt, the possibility of this measure becoming law prompted Moody’s to strip the U.S. of its triple-A credit rating and resulted in tepid demand for a 10-year treasury auction in May, as I noted in a Forbes post last month.

The wide range of uncertainty about when such a break would happen reflects how sudden financial crises tend to be. “We’re talking about psychological tipping points,” asset management firm PGIM’s chief economist Daleep Singh, told the New York Times. “No one can be too confident about how close we are to those tipping points when suddenly the momentum just takes on a life of its own.”

A bond market break is not inevitable. Modest economic growth forecasts, controlled inflation, and fairly stable 10-year bond yield predictions all suggest the bond market could be resilient.

Investors can take steps to protect against Dimon’s gloomy prediction. They could trim longer-term debt exposure, shift funds to short-term treasury securities and buy stock in financial services providers and energy utilities that benefit from higher rates.

Definition Of “bond Market Crack”

A “bond market crack” is a potential disruption within the bond market, where liquidity — the ease of buying and selling bonds — could evaporate.

Financial institutions facilitating bond trades could struggle to handle the volume, leading to sharp price declines in long-duration bonds sensitive to interest rate changes.

Unsustainable fiscal policies, rising interest rates, or sudden shifts in investor confidence could cause such a scenario to occur. That is what happened in 1994’s “Great Bond Massacre.”

In that year, Federal Reserve Chair Alan Greenspan roughly doubled the short-term interest rate to take some air out of what he perceived as a bond market bubble. By September 1994, the worst bond market loss in history had wiped $600 billion from the value of bonds, reported Fortune.

High leverage was a major contributor to that bond massacre. To be sure, a bigger, global bond market, derivatives, and greater trading speed all worked together to blow up the bond bubble.

But the collapse of highly leveraged bond purchases — financed with 1 or 2 cents on the dollar and the rest from banks and securities dealers — magnified the trading losses when bond prices fell, Fortune noted.

Evidence Reinforcing And Undermining Dimon’s Gloomy Prediction

There is a moderate chance Dimon could be right — with evidence reinforcing his prediction offset somewhat by forces undermining it.

In addition to concerns about too much debt, Dimon sees other reasons why a bond market crack is in the offing.

He sees bank regulation in the wake of the 2008 financial crisis as limiting banks’ ability to hold bonds on their balance sheets. Those limits impede the ability of financial institutions to provide liquidity in the event of a break in the bond market, Dimon argued, according to the Journal.

Moreover, rising treasury yields — to north of 5% which are the highest since 2007, according to Bloomberg, suggest investors are reaching their tolerance limit for high debt.

Moreover, narrow credit spreads — as of late February, the Bloomberg High Yield Index Option Adjusted Spread over U.S. Treasuries stood at 2.56%, a level achieved months before the global financial crisis, according to CME Group — reflects under-pricing of default risks in a potentially weakening economy.

While these forces reinforce Dimon’s prediction, others call it into question. Current economic indicators, including steady growth — predicted at 2.4% in the current quarter — and inflation expected to remain below 3%, , according to a forecast from the Conference Board, suggest a low chance of an immediate bond market crack.

Moreover, some experts forecast 10-year Treasury yields to range between 3.5% and 5%, according to Morningstar’s Dominic Pappalardo and BNY Mellon Wealth Management’s John Flahive.

While these forecasts were issued several months ago and may not reflect recent economic policy changes, these range-bound forecasts coupled with the Fed’s planned rate cuts — which may be delayed if tariffs spark a rise in inflation, according to the Times — could mitigate a bond market crack.

Can Investors Protect Their Portfolios From A Bond Market Crack

Investors can protect their portfolios from a bond market crack by shifting their capital from long-duration and junk bonds to short-term bonds, higher quality corporate bonds, and stocks in industries — such as financial services providers and utilities — that benefit from higher interest rates.

Why shift out of long-duration and junk bonds? Long-duration bonds are lose value when rates rise — for example, a 1% yield rise can slash more than 15% from the value of 30-year Treasury securities, noted AIInvest. Investors should exit CCC-rated junk bonds due to higher default risks — reaching 28.6% in 2024, according to S&P Global.

Shorter term bonds are becoming increasingly popular. “There’s lots of concern and volatility, but on the short and middle end, we’re seeing less volatility and stable yields,” bond ETF company BondBloxx CEO Joanna Gallegos, said on CNBC.

Warren Buffett seems to agree. How so? Berkshire Hathaway doubled its take in T-bills and now owns “5% of all short-term Treasuries,” according to a recent JPMorgan report featured by CNBC.

If you prefer stock investing, certain sectors benefit from steeper yield curves and higher rates. These include banks such as JPMorgan and utilities such as NextEra Energy. Moreover, the S&P 500 Financial Select Sector Index tends to outperform during rate hike periods, noted Fidelity Investments.