By Dhara Ranasinghe

LONDON, (Reuters) – The closely watched measure of money market stress and dollar funding conditions rose on Friday to their highest levels since May 2020. This was due to the global knock-on effects from the conflict in Ukraine.

From 23.7 bps Thursday, the gap between U.S. three-month forward rates and three-month overnight swap rates, commonly referred to in London as FRA-OIS spread rose to 25.5 basis points.

This measure reached its highest point since May 2020 and was above a Thursday peak. Higher spreads indicate increased interbank lending risk and banks holding more U.S. Dollars.

Francesco Pesole, ING currency strategist said that “the market’s liquidity conditions are weakening this week and were exacerbated overnight following reports of shelling at Europe’s largest nuclear power plant in Ukraine.”

The fire in a large building located at Europe’s most powerful nuclear station was put out on Friday. Ukrainian officials stated that the facility was still in operation after it was seized in heavy fighting by the Russian forces.

FRA/OIS spread refers to the difference in the Libor (interbank lending rate) and the overnight Index Rate, also known as the Effective Fed Funds Rate. It is the Federal Reserve’s risk-free rate.

This gap is still well below the levels at which the COVID-19-triggered market turmoil began in 2020.

Pesole explained that although this indicates dollar funding conditions at the moment aren’t too worrying, however the recent deterioration naturally points in favor of a stronger currency.

Also, dollar borrowing costs have resumed to rise in swap markets. Three-month swaps between euro-dollar and dollars rose to 21 bps vs. 15 bps on Thursday.

They remained at or below the March 2020 high of almost 40 bps, which was reached on Monday. Similar trends were observed in the dollar swap market, which utilises the yen to borrow dollars.

Analysts believe that if there is a worsening of funding, the Federal Reserve or other central banks can provide relief by creating mechanisms to help short-term financing markets.

The Fed has FX swap lines that are open with many central banks such as the Bank of Japan (ECB), Bank of England (Bank of Canada), and Swiss National Bank.

Eric Theoret of Manulife Investment Management, a global macro strategist said that cross-currency Swaps had been “incredibly well behaved.” We are now in an era where emergency liquidity is readily available so that there’s no need to be afraid of being caught off guard.

Major central banks are increasingly using swap and repo line since the global financial crises. Swap lines are bilateral agreements that allow the ECB to participate in swap lines with five major central banks.

Investors were still paying attention to the funding markets because of increased global uncertainty.

Mike Kelly from PineBridge Investments, global multi-asset head said that while we have all the liquidity it can still disappear quickly. It shows how volatile things can be, and it is not normal.