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European debt downgrade unlikely to budge interest rates

January 17, 2012

| MoneyRates.com Senior Financial Analyst, CFA

Government bonds from France and Italy received a downgrade last week from ratings agency Standard & Poors. As bad as that sounds, it really is a confirmation of a long-recognized problem rather than a sign of new trouble. The downgrade can be thought of more as a symptom of an existing ailment than a sign of any new illness in Europe's financial system.

Implications of the downgrade

Along with France and Italy, seven other European nations had their debt instruments downgraded by Standard & Poors to reflect the uncertainty surrounding the fiscal difficulties of Greece and other nations. Even France, which has maintained relatively sound fiscal policies, is being drawn into the crisis because of its involvement with the euro and the interdependence of European financial institutions.

In theory, a debt downgrade means that the bond issuer -- in this case, the countries involved -- must pay a higher interest rate when it issues new bonds. This effectively raises the cost of borrowing money. It is no different from a credit card holder with a poor credit history having to pay a higher credit card interest rate. As with an individual's debt problems, countries can find their fiscal problems starting to feed on themselves, as a high debt burden brings higher interest rates, which raise the cost of carrying that debt and makes the burden even worse.

In the short run, though, the downgrade of European debt should not have a huge impact. The bonds of these countries are actively traded by institutions which were already well aware of the financial conditions in the countries issuing those bonds, and therefore concerns about default risk were already reflected in the prices of those bonds. The downgrade merely confirmed those concerns, though it could also limit the pool of potential buyers of those bonds in the future.

The contrary interest rate environment

Of course, while poor credit quality generally means higher interest rate, that has not always been the case in the recent interest rate environment. In some ways, the situation is contrary to logic -- widespread concerns about debt have been accompanied by a generally low global interest rate environment. For example, U.S. Treasury bonds have continued to trade at very low yields despite receiving a downgrade last year.

None of this bodes well for interest rates on CDs, savings, and money market accounts. Not only do general interest rates remain extremely low, but the high demand for guaranteed investments should tend to keep savings account rates near zero.

After all, in a situation rife with uncertainty, a guarantee of principal is an attractive thing, even if it comes with little interest income. Low interest rates effectively are the price of safety in today's risky financial world.

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