By Karen Brettell

(Reuters) – U.S. sanctions on Russia should haveten a move of some countries to decrease their reliance upon the U.S. Dollar. This could soften demand Treasuries at a time when the Federal Reserve is looking to lower its bond holdings.

In response to Russia’s invasion of Ukraine, the United States and other Western countries have placed extensive economic sanctions on Russia. These have effectively prevented Russia’s central bank and sovereign wealth fund from being able to enter into U.S. dollars transactions and some individuals.

The world’s most important reserve currency is the dollar. According to analysts, the use of it as a weapon in finance is expected to speed up a trend that many countries are already taking to diversify investment into alternate currencies.

“The more we use it, the more other countries are going to diversify due to geopolitical reasons,” said Zongyuan Zoe Liu, a fellow for international political economy at the Council on Foreign Relations.

The dollar’s reserve status boosts demand for U.S. assets including Treasury bonds and allows the government to issue more debt at lower rates than it may otherwise be able to. Treasuries can also be attractive for investors because the market is bigger and more liquid than most.

Treasuries might not appeal to all investors at the same time as there is more supply, but the end result could be better yields.

As it fights rising inflation, the Fed expects to let Treasuries mature indefinitely without replacing its $8.9 Trillion balance sheet. Benchmark yields on 10-year bonds reached 2.56 percent Monday. This is the highest reading since May 2019.

The dollar may not soon be replaced as the reserve currency, but any shift towards the greenback could result in a less homogeneous global economy, where payments will be more evenly divided between currencies, including the dollar and the euro.

“US dollar debasement (is the) ultimate outcome as dollar weaponized in new era of sanctions,” Bank of America (NYSE:) analysts led by Michael Hartnett noted in a report released Thursday.

The Wall Street Journal revealed this month that Saudi Arabia is in negotiations with China to fix the price of some crude oil that it supplies to China.

Russia has been gradually reducing its dollar holdings since the imposition of Western sanctions following Moscow’s annexation of Crimea in 2014. It stated that it will eliminate all U.S. dollars assets from its National Wealth Fund in 2021 and instead increase its holdings of gold and euros.

Russia’s Treasury holdings fell to negligible levels in mid-2018, and are down from around $150 billion a decade ago, according to Treasury International Capital (TIC) data.

Others have reduced their bonds holdings as well.

China had $1.1 trillion worth of Treasures at the end of January. This makes it second after Japan as the largest foreign owner, down from $1.3 trillion in 2013. China is now buying less of the U.S. government debt, up to $23 trillion, from $12 trillion in 2013.

Saudi Arabia had $119 billion worth of Treasuries in January 2022. This is down from the $185 billion held in February 2020.

Oil producers saw the demand for bonds in the middle 2000s as a key factor to keeping yields down, even though the Fed had just begun a two year hiking cycle.

Thomas Mathews from Capital Economics, an economist and market analyst, stated that oil producers will be less likely to intervene this time, despite the fact they are making a profit off soaring prices.

“The sanctions on Russia will be a bit alarming for many of the major oil exporters that hold large amounts of Treasuries (and US assets in general) and might hasten some diversification plans. That could mean that some of the support for Treasuries from foreign savings, such as we saw in the mid-2000s, could be absent during this tightening cycle,” Mathews said.

These countries may continue to decrease their Treasuries purchases, but they don’t expect to issue large-scale bonds sales. Due to the limited alternatives for safety and liquidity, there may be limitations on countries’ ability to reduce their holdings.

Obligations may attract other buyers if yields keep rising.

“As rates go higher and the prospects of economic slowdown continue to mount there will be a diversification out of risk assets and into Treasuries, such that maybe yields actually kind of steady themselves,” said Thomas Simons, a money market economist at Jefferies. “I think it’s more of a risk for risk assets in this environment than it is actually for Treasuries.”