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Debt Downgrade Unlikely to Push Interest Rates Higher

The humiliation of a credit rating downgrade for the U.S. would exact some psychological damage but is widely viewed as less likely to cause any actual carnage on interest rates.

Few fixed-income experts are looking for a major surge in rates even if Standard & Poor's follows through on its threats to cut the US rating from the coveted triple-A statusdown to double-A.

That sentiment played out vividly through the debt ceiling debate in Washington and hasn't changed since Congress passed a comparatively modest debt reduction law, despite warnings any deal that didn't have an aggressive long-range timeframe would trigger a downgrade.

"The market was very much able to effectively price in the most likely scenario for a small debt deal and an increase in the debt ceiling, in advance of all the dramatics in Washington, D.C., playing out," said Robert Tipp, chief strategist at Prudential Fixed Income in Newark, N.J.

Indeed, yields perked up in early July, pushing toward 3.25 percent on the benchmark 10-year Treasury note, but have retreated since and were plunging toward 2.60 percent in afternoon trading Tuesday.

Bond auctions have been solid if not spectacular as of late, with investors more than willing to accept U.S. debt as the least-bad fixed-income investment while debt problems spread through the European periphery and the domestic economy falters.

"What we've seen happen over the past two weeks is, 1) a major downshifting of the U.S. economic data. That puts downward pressure on U.S. interest rates. And 2) we've seen upward pressure on Italian and Spanish interest rates," Tipp said. "That has raised the specter of contagion in Europe and raised a major flag for the world's central banks in terms of where they can put their money."

The weakened economy, in fact, is seen as something of an insurance policy against a surge in rates even if S&P does cut the U.S. debt rating.

Gross domestic product growth for the second quartercame in at an anemic 1.3 percent, while the previous quarter's number was revised down to 0.4 percent. Projections from many economists earlier in the year that had the U.S. economy growing at a 3.5 percent to 4 percent clip now seem fairly well out of reach.

"Much more fiscal consolidation will be needed, which is likely to act as a brake on economic growth for some years to come," Paul Dales, U.S. economist at Capital Economics in Toronto, wrote in a note to clients. "GDP growth is already on course to disappoint this year and the next few years may be no better. In such a climate, equities will struggle and Treasury yields will remain low."

Capital Economics has been below consensus all year on both GDP growth and interest rates and is sticking to its forecast of a 2.5 percent rate for the 10-year.

The firm also believes a downgrade from S&P could come as soon as this week, but does not see it as "a disaster for the Treasury market or the dollar."

"The bigger picture is that the long-term fiscal position of the U.S. remains perilous," Dales wrote. "A raising of the debt ceiling and a package to reduce the deficit by between $1 trillion and $3 trillion over 10 years will do little to reduce net debt."

The final component in keeping rates low will be accommodative policy from the Federal Reserve , which will be pressured to hold its key funds rate close to zero as the economy struggles to stay above recession levels .

In his most recent statements, Fed Chairman Ben Bernanke has tried to tamp down talk of a third round of quantitative easing. But his hand may be forced if unemployment keeps rising and the economy enters full contraction.

"If consumer spending did weaken, the Federal Reserve may act to make monetary policy even more accommodative, increasing the potential of further quantitative easing," analysts at Keefe, Bruyette & Woods wrote in an analysis. "This is essentially what happened in Japan, when their sovereign debt was downgraded, long-term interest rates declined."

The most material effect the downgrade would have, according to the KBW note, would be a further erosion of consumer confidence that itself would keep rates low. The firm focuses on the financial sector, which it sees as a loser in a downgrade scenario, with insurance firms suffering the most.

"In our view, a one-notch downgrade of debt will have a very minor impact on the cost of Treasury borrowing compared to the impacts of economic growth and Federal Reserve policy," KBW said. "Our primary concern is over the next six to 12 months the negative consumer sentiment surrounding a rating downgrade on the U.S. would have a large enough negative outlook on U.S. growth that the net impact would be lower rates."