This is an important question right now because there are a growing number of problems emerging in the bloated U.S. credit markets.
Companies are boosting debt faster than their revenues. Retailers are going out of business, with more insolvencies expected in the near future, which will inevitably lead to deteriorating shopping-mall values. Energy companies are facing more pain as oil prices start sagging again. And some car buyers and online borrowers are having a harder time repaying their debt than investors expected.
Fund managers are clearly getting worried these small tremors will lead to bigger consequences, especially at a time when yields on riskier assets are relatively low. For example, U.S. high-yield debt investors have moved underweight the bonds for the first time since December 2008, according to a Bank of America Merrill Lynch March credit survey.
Investors have started demanding more yield to own speculative-grade debt, and auto-loan originators have begun to tighten their standards.
Some have withdrawn billions of dollars from the biggest high-yield bond exchange-traded funds in the past week.
These developments could hint at several very different outcomes. The worst-case-scenario is a broad-based deterioration of borrowers’ ability to repay their obligations, which would be odd at a time when economic trends seem generally positive. Such weakness could imply the U.S. economy is closer to a recession than many analysts think, and that the Federal Reserve will only make the situation worse as it raises interest rates.
After all, the Fed created this frothy credit situation by holding benchmark borrowing costs near zero, starting in 2008.
So it makes sense to think raising rates will diminish that exuberance, removing the safety blanket from companies that don't have such bright futures.
There's a best-case scenario, too. This weakness could signal a healthy weeding-out process that's normal in an aging credit cycle. It lets the weakest companies fade away without tanking all markets, allowing true, sustainable growth to speed up over time.
And then there's the reality, which lies somewhere in between. Investors are going to lose more money in riskier credit over the next few years than they have recently. It may even turn into a prolonged, slow drag on riskier asset values and growth, only to finish unwinding during the next recession.
The big short
Some investors will get slammed while others chug along. And there are plenty of cash-flush private-equity firms and distressed-debt funds that can't wait to go on a buying spree after a significant sell-off.
Such an outcome would disappoint all those hedge funds that have been planning for a fantastic blowup akin to the one experienced in 2008. It means they can't be the winners of a Big Short type of bet.
But this is probably why the Fed feels comfortable raising rates, as it did Wednesday for the third time since December 2015. In fact, U.S. central bankers may be happy to nudge this deleveraging process along, especially in light of this year's unprecedented explosion of debt sales.
It makes more sense for central bankers to get this ball rolling now, at a time of economic stability, than to wait until later in the cycle. They may slow the recovery, but that's an acceptable trade-off for letting this weakness run its natural course.