Market Extra: Will Russia-Ukraine war spark a dash for U.S. dollars? Here’s what to watch.

”The largest factor driving the funding market stress was the uncertainty of any contagion effects on global financial markets from sanctions, and the risk that missed payments due to the locking up of Russian-controlled dollars might have a cascading effect,” said John Canavan, lead analyst at Oxford Economics, in a Wednesday research report.

Read: Sanctions take aim at Russia’s economy: Here’s who is most exposed

He wrote, however, that those fears eased as Monday’s session went on, and there were no signs of significant issues or indications of large levered investment funds under pressure.

For example, the spread between the U.S. three-month forward rate agreement and overnight interest swaps, known as the FRA/OIS spread, jumped as high as 24 basis points in overnight action Monday from 13 basis points last Friday before easing back to 19 basis points, Canavan observed (see chart attached). The spread measures the difference between expectations of future Libor, or London interbank offered rate, and the effective fed funds rates. It tends to widen during times of stress.

Scrambling for dollars

War and other geopolitical shocks can contribute to a scramble for dollars around the globe. Such a phenomenon was an early feature of the market chaos in the early days of the COVID-19 pandemic, when the resulting surge in the U.S. dollar was blamed for amplifying a global equity selloff that tipped Wall Street into a bear market and fanned volatility across financial markets.

That risk is one reason for currency traders to err toward long, or bullish, positions on the U.S. dollar for now, said Steve Barrow, head of G-10 strategy at Standard Bank, in a Tuesday note.

Opinion: Sanctioning Russia is a masterstroke that will cement the dollar’s dominant role in world affairs

The risk of another volatile episode can’t be ignored following the move to remove major Russian banks from the crucial SWIFT interbank messaging service, analysts said.

”Exclusions from SWIFT will lead to missed payments and giant overdrafts similar to the missed payments and giant overdrafts that we saw in March 2020,” wrote Zoltan Pozsar, strategist at Credit Suisse, in a Sunday note.

Meanwhile, fears the economic and financial consequences of Russia’s invasion of Ukraine and resulting sanctions will hit the eurozone harder than other developed markets has sent the euro skidding versus major rivals this week, losing 1.4% so far versus the U.S. dollar after trading at its lowest since May 2020. The ICE U.S. Dollar Index
DXY,
-0.04%,
a measure of the currency against six major rivals, with the heaviest weight belonging to the euro, was up 0.8% this week, hitting its highest since June 2020.

Tracking the basis

Among other market indicators, it’s worth keeping an eye on cross-currency basis spreads, Barrow said, which measure the cost of securing dollars through the currency market. During periods of stress, getting access to dollars through the interbank lending market may become a challenge and/or expensive, leading borrowers to turn to the foreign exchange market.

If they do so in sufficient size, it can begin to push around basis spreads, he said, offering a sign that dollar funding conditions are tightening. Just as the euro/U.S. dollar
EURUSD,
+0.03%
is the most heavily traded currency pair, the euro/U.S. dollar basis is the spread to watch, he said.

TED spread

In the U.S., the so-called TED spread, which measures the difference between the rates on Treasury bills and eurodollars is also watched for signs of funding strains, Barrow noted. That spread also widened out early this week, though the scale of the move remained modest compared with past crises. An equivalent measure for the euro zone may be more germane, he said, as European banks, particularly those in Italy, Spain and Austria, have more loan exposure to Russia.

So what’s happening? Pressures are developing, Barrow wrote, but remain ”far short of what we’ve seen during other periods of tension such as the initial COVID wave in early 2020, but basis swaps bear watching closely.”

Meanwhile, the uncertainty about the impact of Russian sanctions will likely ”keep dollar demand strong, which will sustain modest stress on short-term funding markets,” said Oxford Economics’ Canavan. ”In turn, that is likely to keep volatility elevated over the near-term, leaving Treasury yields at risk for larger swings,” he said.

Related: Signs of stress are emerging across the U.S. rates market, exacerbated by Russia-Ukraine crisis

Faith in the Fed?

The Fed moved quickly in the spring of 2020 to lower the cost of borrowing dollars via existing swap lines with major central banks, then went on to add new swap lines with a number of other central banks, including some emerging markets in an effort to meet demand for the currency.

Canavan said those swap lines could be quickly reopened or re-established if things get ugly. In addition, foreign and international monetary authorities can temporarily exchange U.S. Treasury securities held with the Fed for U.S. dollars at the Fed’s standing repurchase agreement facility.

Credit Suisse’s Pozsar said the Fed needs to be ready to reactivate those lines, drawing a comparison with the 2008 collapse of Lehman Brothers.

”Banks’ inability to make payments due to their exclusion from SWIFT is the same as Lehman’s inability to make payments due to its clearing bank’s unwillingness to send payments on its behalf. History does not repeat itself, but it rhymes,” he said.

”The consequence of excluding banks from SWIFT is real, and so is the need
for central banks to re-activate daily U.S. dollar-funds supplying operations,” Pozsar wrote. He added that if policy makers are forced to act, the Fed could end up adding to its balance sheet before it gets a chance to begin quantitative tightening.

Canavan argued that recent history means that market dislocations will likely remain ”fairly muted” overall.

”Investors recognize the Fed will be quicker to react, and this alone will keep markets calmer,” he wrote.