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Dollar funding stress signals flash as war fallout deepens

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A closely-watched measure of money-market stress and dollar funding conditions rose again on Friday to its highest level since May 2020, as the knock-on effects of the war in Ukraine rippled out globally.

The gap between the U.S three-month forward rate agreement and the three-month overnight index swap rate, also referred to as the FRA-OIS spread, rose to around 25.5 basis points in London from 23.7 bps on Thursday.

The measure was its highest level since May 2020, surpassing a peak hit Thursday. A higher spread reflects rising interbank lending risk or banks hoarding U.S. dollars.

“The market’s liquidity conditions have weakened this week, and were exacerbated overnight after reports of shelling to Europe’s largest nuclear plant in Ukraine,” said ING currency strategist Francesco Pesole. A huge blaze in a building at the site of Europe’s biggest nuclear power station was extinguished on Friday and officials said the plant in Ukraine was operating normally, seized by Russian forces in heavy fighting that caused global alarm.

The FRA-OIS spread measures the difference between the three-month Libor or the inter-bank lending rate and the overnight index rate, or the effective fed funds rate — the risk-free rate set by the Federal Reserve on the othr.

The gap remains well below levels seen at the height of the COVID-19 triggered market turmoil early in 2020.

“This suggests that dollar funding conditions are not too alarming at the moment, but the deterioration in the past week naturally argues in favour of a stronger dollar,” Pesole said.

Dollar borrowing costs also resumed their rise on swap markets, with three-month euro-dollar swaps rising to more than 21 bps, compared to 15 bps on Thursday.

However, they remained below a March 2020 peak of nearly 40 bps hit on Monday. A similar trend was seen in dollar borrowing costs via the yen and the pound swap markets .

Analysts said that should funding stress worsen, the Federal Reserve and other major central banks have mechanisms in place to relieve short-term funding markets.

The Fed maintains standing FX swap lines with a number of central banks, including the Bank of Japan, European Central Bank, Bank of England, Bank of Canada, and the Swiss National Bank.

“Cross-currency swaps have been incredibly well behaved,” said Eric Theoret, global macro strategist at Manulife Investment Management. “We are in a world now where the emergency liquidity facilities stand at the ready so there’s less of a fear about a scramble.”

Swap and repo lines have been increasingly used by major central banks since the global financial crisis. The ECB is part of a swap line network of standing bilateral arrangements with five other major central banks.

Still, heightened global uncertainty meant investors were watching funding markets closely.

“We have all this liquidity but it still has the ability to disappear suddenly,” said Mike Kelly, head of global multi-asset at PineBridge Investments. “It shows how skittish things are and we are not in normal times.”