US credit downgrade risk grows as debt hits $40 trillion

A former State Department economist says a U.S. credit downgrade "may very well be warranted" as federal debt crosses $40 trillion and long-dated yields climb.

A U.S. credit downgrade "may very well be warranted," former State Department deputy chief economist Philip Luck said, as federal debt crossed $40 trillion and the 30-year yield hit its highest since 2007.

"The fiscal and credit position of the United States has deteriorated to the point where a downgrade may very well be warranted," Luck said in an interview Wednesday.

The Treasury Department said federal debt reached a record $40 trillion for the first time. The 30-year government bond yield touched its highest level since 2007 this week, while the 10-year yield stood at 4.53 percent. The U.S. now pays about $3 billion a day in interest, making debt service the second-biggest federal expense after Social Security. Total sovereign debt equals 120 percent of GDP.

A downgrade would push Treasury yields higher and lift borrowing costs across the economy — the average 30-year fixed mortgage rate already sits at 6.67 percent, near a one-year high. It could also trigger a broad risk-off move in equities, with the VIX at 18.26 and the S&P 500 trading at about 23 times forward earnings.

The last time a major agency stripped the U.S. of its top rating, S&P Global cut it in August 2011 after a debt-ceiling standoff. The S&P 500 fell about 6 percent in the days that followed while gold rallied to a record, a template for how a downgrade could ripple through markets again.

Bond investors have been demanding higher compensation for holding U.S. debt as successive administrations ran deficits. President Donald Trump's second-term tax-cut extension, signed alongside higher border-security spending, added to the pile. Rising yields have begun to spill into consumer credit: credit-card and auto-loan rates track government bond yields, and mortgage rates have climbed in tandem.

The divergence between bond and equity markets explains why stocks have held near records even as yields climb. Bond investors focus on repayment risk and demand higher interest as the debt pile grows, while stock investors bet on corporate profits, which have stayed strong on the back of AI-driven earnings growth. That gap narrows if higher borrowing costs begin to slow consumer spending, the engine of the U.S. economy.

A Downgrade Would Lift Yields and Squeeze Equities

A downgrade would compound the pressure. Higher Treasury yields raise the government's own borrowing costs — already $3 billion a day — and squeeze equity valuations as the risk-free rate climbs. The dollar could weaken as foreign holders reassess the safety of U.S. assets, while gold, a traditional haven, would likely draw inflows.

The Federal Reserve, which cut its target rate to 3.50-3.75 percent in December, retains room to cushion any shock. But with a new Fed chair due to be appointed in May and the White House pressing for lower rates, the policy response to a downgrade is uncertain. If yields keep climbing, the equity market's record run — built on AI-driven earnings growth — faces its first serious test since the 2022 bear market.

This article is for informational purposes only and does not constitute investment advice.