A downgrade to the U.S. sovereign credit rating could open up a new world of pain for the dollar.

Already reeling from low interest rates, slow economic growth, and foreign investors eager to diversify away from U.S. assets, the loss of AAA status could cement the view the dollar is no longer the safest harbor in a troubled world.

The risk of a downgrade remains real even after Washington's $2.1 trillion budget savings deal, since it fell well short of the $4 trillion Standard & Poor's said would be enough to support the AAA rating with a stable outlook.

That it took so much drama to produce such a limited round of cuts has disappointed investors who had grown weary of fiscal weakness during budget crises in the euro zone countries.

A debt ceiling raised plus downgrade equals weak dollar, said Jonathan Lewis, founding principal of Samson Capital Advisors in New York, which manages assets of $7 billion.

Not only would a double AA rating be a concern for international investors, but the fiscal imbalances would not be a good reason to buy the dollar.

For years, the dollar has acted as the world's reserve currency, an international store of value for central banks.

However, the fact the other safe-haven currencies are gaining at the expense of the dollar suggests investors' views may already be changing, perhaps in anticipation of a downgrade or at least a tough fight to hang on to AAA.

Over the last month, the dollar plummeted 6 percent against the Swiss franc and about 4 percent against the yen.

Being the world's reserve currency seems incongruous with a double-A rating, said Barclays Capital in a research note.

The only consolation, perhaps, is that the dollar has risen more than 1 percent over the past month against the euro, though only because the euro zone itself is under the gun over fiscal problems of Greece and Italy.

THE JAPAN EXPERIENCE

The fact that the yen has retained much of its value in the face of a Japanese downgrade over the past decade, including the most recent action by S&P earlier this year, does not suggest the dollar would be similarly immune, analysts said.

The yen is not the world's primary reserve currency, representing just under 4 percent of global reserves. The dollar is, with its share of global reserves at 60.7 percent.

With dollar holdings so much larger than the yen and every other currency...the risk stemming from a downgrade or other negative shocks is potentially larger, said Bob Lynch, global head of G10 currency strategy at HSBC in New York.

In addition, the bulk of Japanese government debt is held locally in Japan, which cushioned the country's bonds and yen from foreign selling. By contrast, roughly half of U.S. Treasuries are held overseas, leaving the dollar far more exposed to selling by foreign investors.

MIND-BENDER?

But the dollar's fall from grace -- which some argue has been underway for several years already -- may come in fits and starts. The immediate outlook is a volatile one.

Indeed, if investors were suddenly faced with a downgrade to the U.S. sovereign credit rating, they might do what they've always done in times of market angst -- buy dollars.

If a downgrade is accompanied by a risk-off environment, that would be a case where the dollar would rally, said Aston Chan, portfolio manager, at $1-billion global macro hedge fund GLC in London. People would always want dollar liquidity when times are tough.

The dollar rallied sharply at the height of the global financial crisis in the second half of 2008 as global investors dumped their own currencies and sought refuge in the greenback.

A top concern about a downgrade is a possible liquidity squeeze that produces turmoil in money markets because lenders suddenly demand more collateral.

Borrowers often use Treasuries as collateral, especially in the $1.6 trillion repurchase market, a key source of short-term funding for banks and Wall Street. As a result, they could be forced to post more, creating a sudden demand for U.S. bonds.

Whether it's about fears of a ratings cut or concerns about global growth, investors are already witnessing some stress in the money market.

The overnight rate on U.S. repos spiked to 38 basis points on Monday, its highest level since December, suggesting there is less cash in the banking system. The rate came down to 13 basis points on Wednesday, still above the zero to two basis points two weeks earlier.

Treasuries remain the benchmark for global yields and as well are a key source of funding and collateral in the money market. The Treasury market also remains the deepest and most liquid fixed income market in the world, said HSBC's Lynch.

This may be the one factor that could help limit the dollar's fall, although probably not for long. The challenges facing the dollar are far too formidable and investors who have long supported the currency are fast running out of reasons to own it.

(Editing by Andrew Hay)

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