AP Photo/Susan Walsh
- A deadline is approaching for lawmakers to reach a deal on raising the $31 trillion debt limit.
- US bonds may "ironically" rally if Congress can't reach an agreement, says UBS.
- UBS says the risk of a US debt default as "very low".
The clock is ticking down for US lawmakers to come up with a deal to raise the country's $31 trillion debt limit, but not reaching an agreement could ignite a counterintuitive rally in the Treasury market, says UBS.
The US could run out of money as soon as June 1 and that could throw the US into an unprecedented economic crisis, Treasury Secretary Janet Yellen said this week. Congress not raising the debt limit to allow the government to meet its obligations will lead to a default, she said.
UBS said sovereign-default risk is "very low" as it's confident that Treasury would prioritize principal and interest payments on its debt.
"Such an outcome, however, would still likely entail cuts in spending elsewhere, which could lead to a sharp hit to economic growth, and likely recession," Evan Brown and Luke Kawa at UBS Asset Management wrote in a May 2 note.
"Ironically, Treasuries would likely rally if the US fails to reach a debt ceiling agreement given the expected material hit to growth," they said.
That indicates that investors would still see US debt as a relatively safe haven the face of an economic contraction. The US has never failed to meet its debt obligations, but it lost its Triple AAA credit rating at S&P in 2011 as the country edged closer to a default.
Worries that Republican and Democratic lawmakers will still be at a political stalemate in the coming weeks have prompted investors recently to exit short-term Treasury debt, sending yields higher. The 3-month Treasury bond yield this week pierced above 5%, the highest since 2007.
While yields hold upside risk, an inability of lawmakers to craft a near-term resolution and potential fiscal fallout will keep a lid on how high US Treasury yields can rise, UBS said.
"This limits some of the downside risk for corporate bonds on an all-in basis. And from a broader market perspective, fiscal policy that contributes to below-trend growth may be part of the solution to the lingering inflation problem," it said.
For now, the global economy looks more likely to be in for a "slow" slowdown rather than a "sudden stop," partly as labor markets in the US and Europe are still tight, the asset managers said.
"Expensive" large-cap US stocks are pricing in a soft landing, while bonds are pricing in too much recession risk. "As the economy remains resilient, we see yields drifting higher and the growth-heavy S&P 500 moving lower in the near term," they said.
UBS' Wealth Management team recently set a one-year end base case price target on the S&P 500 at 3,800 and said it prefers bonds over equities. The index outlook implies a nearly 8% fall from Tuesday's close of 4,119.58. Its bull case target is 4,400, or a roughly 7% increase from Tuesday's end.