The moment that Wall Street has long been dreading could happen this week.
The Federal Reserve on Thursday may increase interest rates for the first time in more than nine years. A rise would be the beginning of the end of a monetary stimulus policy that lifted stock and bond markets to new heights and brought the good times back to Wall Street after the crash of 2008.
History, however, shows that booms financed with cheap money often leave the financial system weaker, not stronger. And the fault lines start to become obvious only when the Fed starts to tighten monetary policy.
This time around, most analysts aren’t expecting 2008-style instability, unless, say, China’s economic problems worsen sharply. The Obama administration’s overhaul of Wall Street appears to have made the largest banks more resilient to the sort of stress that can follow an increase in interest rates.
“I believe that Wall Street is better prepared for a market event than it was in 2008, partially as a result of regulation but, more importantly, as a result of experience,” said Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission.
A liftoff in rates may not happen this week. After a violent downturn in global stock markets last month, prompted by concerns about China, traders are now betting that the big day is more likely to happen at the Fed’s December meeting.
But an increase in rates, whenever it comes, could still roil markets, make it harder for many firms to raise money and expose new frailties in the system that postcrisis regulations have not properly addressed
In theory, a small increase in interest rates — the Fed is expected to raise them by only a quarter of a percentage point this year — should not be enough to wreak havoc. If the real economy is reasonably healthy and corporate earnings continue to grow steadily, which seems possible, then stock and bond prices should not be vulnerable.
Still, some analysts have a darker view of the links between the Fed’s $3.5 trillion stimulus, Wall Street and the wider economy. They say that financial markets have played a central role in funneling trillions of dollars into investments that will prove unsustainable when interest rates go up.
“The Fed is supposed to remove the punch bowl just as the party gets going,” said Albert Edwards, a strategist with Société Générale, in an email exchange. “It is already well past midnight, but the guests will keep partying until they drop if you ply them with even more alcohol.”
And signs of excess abound.
Technology companies have been able to raise large sums even before they tap the public markets. This is a sign that investors are so hungry for a stake in the latest boom in Silicon Valley that they are willing to tolerate long waits before they can sell out and are willing to forgo more detailed financial statements.
The debt markets have long appeared overly eager to lend. Around the world, companies with a credit rating that is B or lower — the less creditworthy of the junk bond issuers — have sold debt worth $1.24 trillion since the start of 2009, when the Fed’s stimulus began in earnest, according to data from Thomson Reuters. That sum is nearly three times the total for the 10 years before 2009.
At the same time, low interest rates have made investors more willing to buy stocks at historically high valuations. The low rates have also made it cheaper for companies to borrow money they can use to buy back their own shares. Repurchases of stock can bolster a company’s earnings per share — an important measure of a corporation’s profitability — because they reduce the number of shares outstanding.
But stock buybacks do not improve the underlying performance of companies. Since 2012, quarterly earnings per share at companies in the Standard & Poor’s 500-stock index have on average grown by 6.7 percent a year. A fifth of that growth rate has come from buybacks, according to an analysis by Deutsche Bank.
Because these sorts of financial activities have been going on for so long, the doomsayers say they are vulnerable to a slight increase in interest rates. Companies may find it much harder to raise money, leading them to curtail buybacks and, much more important, shelve investments.
Such a reversal is already causing stress in large developing countries like China and Brazil. Fears that weakness in emerging markets might end up damping growth in developed economies were behind the steep sell-off in stock markets in August.
But many of the gloomier analysts have been predicting a great reckoning for years — and it hasn’t happened. The excesses in the system, for instance, may not be as widespread as in past booms. The new restraints on Wall Street and the housing market have so far prevented a resurgence of the toxic real estate lending that occurred when interest rates were low a decade ago.
It is also not clear that the Fed’s easy money policies have been that easy.
After accounting for inflation, corporations are not borrowing more cheaply than they did in the past. Since the end of 2008, the average, inflation-adjusted yield on corporate bonds of moderate credit risk has been 4.1 percent, compared with 3.94 percent for most of the postwar period.
At the same time, the Fed’s policies appear to have prompted a surge in a type of lending that might prove more stable than the securities markets under higher interest rates. In the last five years, banks of all sizes, often operating far away from Wall Street, have increased loans to corporations by over $700 billion, or 61 percent.
In any case, a rise in interest rates may not prompt companies to slash the size of their stock buyback programs. An analysis by Deutsche Bank suggests that companies’ cash holdings and cash flows generated by their operations could cover their buybacks. The analysis also shows that companies’ debt loads, when measured against their market value, are at historical lows.
And if buybacks do become less attractive to corporations, there could be a silver lining. It might prompt executives to instead invest spare capital in their operations as they seek higher productivity.
“It would mark a shift toward the old-fashioned growth model,” said Atul Lele, chief investment officer at Deltec International, an investment firm
But some experts who are not that worried about the strength of banks or speculative excesses still have their concerns. They tend to center on the workings of the markets themselves. These fears were deepened by the so-called flash crash in the stock market in May 2010, when some stocks suddenly became worth mere pennies, and a startling, but brief, spike in the price of Treasury securities last October.
And high-frequency trading has ballooned over the last 10 years. Firms using automated trading perhaps now account for half of all trades in the market for Treasury securities. Exchange-traded funds, whose shares are supposed to be closely tied to the value of their underlying assets, are now a major force in the stock market. If heavy selling is widespread across many markets, the smooth functioning of these products and markets may be tested.
The performance of exchange-traded funds in the recent sell-offs may be a foretaste of what might happen. For a short period on Aug. 24, shares in some funds fell to prices that were well below the value that they would have commanded had they stayed in line with the worth of the fund’s underlying holdings. An investor selling at that discount might take an unnecessary loss.
“The implication of E.T.F.s and their disconnect from their underlying securities is very worrying,” Mr. Levitt, the former regulator, said. “That has a tendency to create great uncertainty in the markets.”