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Contrary to popular belief, Standard & Poor's has not reduced its rating on U.S. government debt--at least not yet. Last April, S&P did reduce its outlook on U.S. government debt. That was its way of warning that a downgrade was possible. In particular, at that time, S&P assigned a one-in-three chance of reducing the rating within two years. Last week, S&P made things more formal. It placed U.S. government debt on CreditWatch negative. This time S&P said there is a one-in-two chance it will reduce the rating within 90 days.

This is serious stuff. Investors have long considered U.S. government debt to be risk free. Business schools have long encouraged this line of thinking. Finance professors all across the country have long taught their students about the Capital Asset Pricing Model. One of the variables in the CAPM is the risk-free rate of interest, which is merely a theoretical concept. But professors have told their students that it is probably safe to assume that the rate on U.S. Treasury securities is a good proxy for the theoretical risk-free rate. Not anymore. S&P's threat to downgrade U.S. debt means Treasury securities should not be considered risk free.

All things equal, a reduction in the credit rating should result in higher interest rates because higher perceived risk means investors will demand greater expected return. Higher rates for government debt will likely mean higher rates for all kinds of loans, including home mortgages. Clearly, that's not a good thing when the housing market is in such bad shape.

If there is any glimmer of hope, it is that a downgrade in America's credit rating may not cause interest rates to rise as much as many investors currently fear. This is because relative to other countries, U.S. government debt will still look good. I am not saying that rates won't rise. I'm only saying that any increase may not be as great as some people expect. That's assuming, of course, that inflation remains tame.

Source: Interest Rates May Not Surge After Ratings Downgrade