A few months ago, as the summer was drawing to a close, Russia’s increased involvement in Ukraine was weighing heavily on the minds of traders who worried that it would lead to an all out proxy war between the US and Russia. However, instead of engaging in a traditional battle, the Obama administration chose to fight Russia on the financial battlefield. In concert with their allies, the US imposed a series of economic sanctions designed to cripple the Russian economy. On September 12th it was reported that:

“Given Russia’s direct military intervention and blatant efforts to destabilize Ukraine, we have deepened our sanctions against Russia today, in concert with our European allies,” said Treasury Secretary Jack Lew.

I also believe that in concert with the Saudis, the Americans orchestrated a decline in the price of oil designed to further pressure the Russian economy (amongst other things).

The goal of Obama’s strategy was to strike a blow to Russia using economic warfare. In that regard, the strategy was extremely successful. The Russian economy has since been in free fall.

Last night, in an attempt to defend the plunging Ruble, the Russians were forced to increase their short term interest rate from 10.5% to 17% . Far from steadying the decline, the dramatic interest rate increase has only accelerated the decline in their currency.

But I wonder if the US and the Europeans have really thought through what they have done. There might be unintended consequences that they have not considered.

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From a military point of view, the Americans keep applying pressure on the Russians, but they are not the kind of people who are simply going to roll over.

“The decision of the US Senate is extremely dangerous. If it is supported by the House of Representatives and signed by their president, Russia must reply with adequate measures,” Mikhail Yemelyanov of the Fair Russia party told reporters on Friday.

“It is quite possible that we should return to the decision by our Upper House and give the Russian president an opportunity to use military force on Ukrainian territory preemptively. We should not wait until Ukraine is armed and becomes really dangerous,” the lawmaker stated.

Yemelyanov also noted that in his opinion the US Senate’s decision to arm Ukraine had revealed that Washington wasn’t interested in the de-escalation of the Ukrainian conflict. He then said that US actions gave him the impression they was seeking to turn Ukraine into some sort of an “international militant targeting the Russian Federation.”

“In a few years Ukraine will turn into a poor and hungry country with an anti-Russian government that will teach its population to hate Russia. They will be armed to the teeth and Ukraine and US reluctance to recognize the Russian Federation within its current borders would always provoke conflicts,” the MP said.

I am not sure how to discount the possibility of Ukraine spinning into a full out war, but I do know one thing – the market has built in virtually zero chance of that outcome. During the summer every report that a tank moved near the Ukraine/Russian border caused a dip in the market. However since it has become obvious that the Obama administration would not be fighting a traditional war, the market has ignored all military developments. If the continued American/European economic pressure causes Putin to launch a full out war, the market would be ill prepared as an escalation has not been discounted at all.

Even if the situation doesn’t descend into a traditional military conflict, do you really think that Putin is going to allow his economy to be attacked without retaliating? So far he has not been able to do much except try to staunch the bleeding, but I am worried there might be an economic counter punch coming. Maybe Putin shuts off the gas to Europe. Maybe he organizes some sort of coordinated selling of US assets. Don’t forget that during the last crisis, according to previous Treasury Secretary Paulson, Russia tried to persuade the Chinese to sell their US holdings:

The Russians made a “top-level approach” to the Chinese “that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies,” Paulson said.

“The report was deeply troubling — heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets,” Paulson wrote. “I waited till I was back home and in a secure environment to inform the president.”

I am not sure where the US is most vulnerable to a Russian attack, but you have to assume that Putin is busy trying to find the weak spot. The market has not discounted any sort of retaliation. I think the market is being short sighted.

However, even if I am wrong about a Russian counter offensive, either militarily or financially, the Obama administration might have started a ball rolling that they will soon desperately wish they could stop. Although the stock market bulls will tell you that the last six months of gains are the result of improving fundamentals, I refuse to buy into that notion. The financial system is dangerously perched on an ever increasing mountain of Central Bank balance sheet expansion. The response to the 2007/8 credit crisis has been to blow an even bigger bubble. I know there are lots of arguments of why this isn’t a bubble – ignore them. Bubbles always seem justified when you are in them. Just like the shale oil guys had all sorts of reasons why their boom wasn’t a bubble, eventually reality sets in and the truth cannot be ignored.

Obama has probably over estimated the strength of the US economy. He has probably fooled himself into believing that the Russian fallout will not infect the US markets. I suspect he is wrong. Once these things start to unwind, they are very difficult to stop.

I am not saying that you should run out this morning and start hitting bids. I am not sure if the bulls are going to be able to defend these levels for year end markings or not. But I do know that over the long run, the markets are ill prepared for any sort of reaction from Putin, and they have underestimated the contagion effects of the economic collapse that the US has unleashed on Russia.