U.S. Debt Default Risk Rises to 1%, Driving Up Interest Costs

For decades, investors have considered the risk of a U.S. government debt default to be virtually zero. This period of perceived safety is now a thing of the past. While the U.S. government is still unlikely to default on the nearly 3 trillion dollars in global circulating debt, global investors are increasingly concerned about the rising risks associated with U.S. debt, and they believe that Congress and the Trump administration are indifferent to these risks.

This rising risk could be driving up interest costs for all U.S. borrowers, whether they are financing a home, car, or business investment. A new paper from the Chicago Federal Reserve uses a complex financial tool known as a credit default swap (CDS) to estimate the risk of a U.S. debt default. The analysis highlights the damage caused by Congress's political infighting over budget issues over the past 15 years and reveals a surprising decline in market assessments of U.S. credit ratings.

Congress may soon pass a tax cut bill that could further jeopardize the U.S. fiscal situation, exacerbating the problem. Market concerns about U.S. credit focus on two main issues. First, the massive borrowing required to finance the government's nearly 2 trillion dollars in annual deficits. The total U.S. debt has reached 3.62 trillion dollars, with the circulating debt currently equivalent to about 100% of GDP, a record for peacetime. This ratio is expected to continue rising.

The second issue is the U.S. debt ceiling, which limits the total amount of federal borrowing allowed by the Treasury. The debt ceiling itself is not the problem, but the way Congress handles it is. In 2011, 2013, and 2023, Congress agreed to raise the borrowing limit only after the Treasury was on the brink of running out of funds. If the Treasury fails to pay even a single maturing debt, it would constitute a default and cause turmoil in the global debt market, the most widely traded asset.

In January of this year, the Treasury once again hit the debt ceiling. Since then, it has been relying on "extraordinary measures" (essentially shuffling funds) to pay bills. Congress must quickly raise the debt ceiling again, and the Treasury's operating space may run out sometime between mid-summer and late summer.

A credit default swap is a private contract similar to insurance, where one party agrees to cover the losses of another if a specific security issuer defaults. CDS contracts for government debt are most active during debt crises in countries like Argentina, Brazil, Mexico, Russia, Turkey, Greece, and Italy. The CDS market for U.S. debt is usually quiet, but it becomes active whenever the U.S. needs to raise its debt ceiling, as congressional delays could trigger a default.

The Chicago Fed's research uses CDS pricing data to estimate market perceptions of U.S. default risk over the past 14 years. In 2011, the U.S. was just days away from default before Congress reached an agreement to raise the debt ceiling. That stalemate led to the first downgrade of U.S. credit ratings by Standard & Poor's.

The Chicago Fed's paper estimates that the peak default risk in 2011 exceeded 6%. During the debt ceiling standoffs in 2013 and 2023, CDS pricing showed peak default risks of around 4%. Currently, CDS pricing indicates that the U.S. default risk is around 1%. The risk is lower than in previous standoffs because the Republican Party controls Congress and can raise borrowing limits without negotiating with the opposition. However, as the Treasury approaches the "X date" when funds run out, this 1% risk could rise further.

While a 1% default risk may seem insignificant, it is not. "Everyone says the U.S. will never default," said David Kotok, co-founder of Cumberland Advisors. "But some people don't believe it. The CDS market shows that the risk is greater than zero." Kotok estimates that the rise in perceived default risk has increased typical mortgage rates by about 0.3 percentage points. This is because investors demand higher rates for riskier securities, such as 10-year Treasury bonds, which serve as the benchmark interest rate for most business and consumer loans.

For a 30-year mortgage on a mid-priced home, reducing the interest rate by 0.3 percentage points would decrease the monthly payment by about 66 dollars, or 792 dollars per year, and 23,769 dollars over the entire loan period. While this may not seem like a large sum, savvy investors value every marginal gain.

Congress could eliminate the debt ceiling altogether by repealing a 1917 law aimed at simplifying government borrowing, not creating a default mechanism. At that time, the executive branch required congressional approval for each specific loan. The debt ceiling was supposed to allow the Treasury to borrow freely within a certain limit. Until 2011, this mechanism worked as intended—when Republicans controlled the House of Representatives, they used the debt ceiling as leverage to negotiate spending cuts with Democrats who controlled the Senate and the White House.

Repealing the debt ceiling could eliminate the U.S. debt CDS market, as the debt ceiling deadline is the source of default risk. No one would complain about this. Kotok estimates that a 30 basis point premium on U.S. interest rates would disappear.

At that point, the U.S. government would face only one debt problem: its enormous size. This year, the market has been dissatisfied with the ever-expanding national debt, and investors have shown unprecedented hesitation in purchasing certain U.S. assets. This has become another factor driving up U.S. interest rates, which should have remained stable or declined in normal market conditions.

Jamie Dimon, CEO of JPMorgan Chase, is the latest to warn about U.S. debt, saying that "cracks" in the bond market could foreshadow impending market turmoil. This is most likely to happen when more investors avoid U.S. assets, including Treasuries, causing interest rates to rise further. Treasury Secretary Steven Mnuchin, however, said Dimon overreacted, providing cover for Republicans pushing a massive tax cut bill that could add another 3 trillion to 4 trillion dollars to the national debt.

Following Fitch's first downgrade of U.S. debt in 2023, Moody's downgraded U.S. debt for the first time in May. Like Standard & Poor's in 2011, both rating agencies cited political dysfunction and massive annual deficits. The discontent with U.S. fiscal profligacy is growing louder. Eventually, Washington will have to listen to these voices.