If intensifying US monetary tightening should be theoretically bullish for Treasury bonds because it hits demand, the macro situation has become much more complicated than it used to be from the potentially lasting inflationary supply shock caused by the ongoing conflict in Ukraine and the related decision to try and expel Russia, a major producer of energy, industrial and agricultural commodities, from the world economy.

At the time of the initial aggressive moves made by the NATO alliance, in terms of imposing sanctions in late February-March, there was a triumphalist narrative in the Western media playing down the importance of the Russian economy.

And it is certainly the case that the Russian economy is relatively small on an international basis.

Thus, Russia accounted for only 1.8% of world nominal GDP in 2021.

Still Russia produces stuff which the world needs in terms of energy and industrial commodities.

This is all part of the revenge of the physical, in the context of the previous obsession with digitalia, and is why Russia’s current account surplus has been surging with the resulting strength of the rouble.

Russia’s current account surplus rose to a record US$138.5bn in the first six months of 2022, or 3.5 times the US$39.7bn recorded in the same period last year, according to the Bank of Russia.

Russia current account balance

Source: Bank of Russia

While the balance of goods and services rose 2.6 times from US$60.5bn in January-June 2021 to US$158.4bn in January-June 2022.

The Rouble has appreciated by 110% against the US dollar and 169% against the euro since early March.

Rouble/US$ and Rouble/Euro (inverted scale)

Source: Bloomberg, Moscow Exchange

Is Russia’s Strategy Working?

Does this mean Russia’s strategy is working?

In one sense yes, in terms of the predictions of a rouble collapse following the Ukraine invasion having been proved entirely wrong.

But it should also be remembered that the rouble’s strength also reflects the collapse in imports in terms of depressed domestic demand in Russia.

Russia exports and imports of goods and services

Source: Bank of Russia

What is Russia’s Current Energy Strategy?

Meanwhile, it would be very bullish, from the standpoint of reducing current inflation concerns, if there could be some kind of settlement of the Ukraine conflict.

But that does not appear likely at present.

That said, the negative economic consequences of the Ukraine conflict, in terms of the boomerang effects of sanctions on the Western world, are beginning to come into more focus as opposed to the previous rush to engage in virtue signaling.

There is also the not small matter of growing Russian retaliation in terms of the reduction of gas supplies to Europe, and in particular to Germany.

Thus, Russia’s Gazprom in mid-June cut gas flows through its Nord Stream 1 pipeline to only 40% of capacity, affecting flows to European countries including Germany.

As a result, the estimate is that Russia’s gas supplies to Germany have already declined by 60%.

The calculation from Moscow seems to be that rather than let Europe stock up on its gas supplies and wait for them to transfer their demand to American LNG suppliers, Gazprom’s leverage should be applied now.

This is why the direction of travel is now towards energy rationing in Europe which would be extremely recessionary.

Calls for a Ukraine Compromise will Grow with Energy Rationing Across Europe

The start of a Western reassessment of Ukraine has gone hand in hand with a belated admission that the conflict is not going quite as badly for Moscow as used to be the case, in terms of the Russian offensive in the Donbas region and evidence of a protracted stalemate.

Still, if the neo-cons in Washington are no longer having it quite all their own way, with French President Emmanuel Macron for example warning recently against humiliating Russia, the Biden administration’s decision at the end of May to supply Ukraine with longer-range multiple launch rocket systems, as part of a further US$20bn military aid package, will likely keep the conflict going for now.

Still, there are likely to be more voices in Europe, and even in America, questioning the current strategy, as the economic costs become ever more apparent.

One point is evident. Financial markets would celebrate a resolution of the conflict along the lines proposed recently by Henry Kissinger, however unlikely that looks at present.

The 99-year-old former secretary of state Henry Kissinger, speaking from Davos in May, called for a return to the “status quo ante” where Russia controls the Crimea and the two easternmost regions of Luhansk and Donetsk (see Washington Post article: “Kissinger says Ukraine should cede territory to Russia to end war”, 24 May 2022).

Kissinger also made the point that pursuing the war beyond “that point” (i.e. status quo ante) would “not be about the freedom of Ukraine, but a new war against Russia itself”.

About Author

The views expressed in Chris Wood’s column on Grizzle reflect Chris Wood’s personal opinion only, and they have not been reviewed or endorsed by Jefferies. The information in the column has not been reviewed or verified by Jefferies. None of Jefferies, its affiliates or employees, directors or officers shall have any liability whatsoever in connection with the content published on this website.

The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Grizzle hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.