Russia digs in its heels
While initially rattled markets appear to be settling down, the latest sanctions and Moscow's likely retaliatory actions will also hurt Europe
The strains are showing on Vladimir Putin, Russia's autocratic and increasingly nationalist president.
Russia is engaged in a bitter geopolitical standoff with the United States and Europe over Ukraine, a former Soviet state whose new government is seeking to integrate much more closely with the West in the face of opposition from the mainly ethnic Russian population in eastern Ukraine.
The tragic downing on July 17 of Malaysia Airlines flight MH17, killing all 298 people on board, has turned Western denunciation of Moscow's support for pro-Russian rebels - who the US accuses of shooting down the plane with a missile provided by Russia - into growing condemnation of the Putin regime.
Having been reluctant to impose tough and meaningful sanctions on Russia for fear of inflaming East-West tensions further and inflicting pain on its own weak economies, the European Union approved far-reaching sector-wide sanctions against Russia on Tuesday covering the energy, defence and banking industries.
This is not what Putin expected - nor is it what financial investors, who had recently turned more bullish on Russia in the belief that the EU lacked the resolve to toughen its sanctions regime - anticipated.
Since the downing of MH17, the Russian rouble has lost nearly 4 per cent against the US dollar. Russian stocks are set to suffer their worst monthly loss since May 2012, with Moscow's Micex index trading at just 4.9 times estimated earnings, the cheapest among the main emerging markets, according to Bloomberg. Moreover, the yield on Russia's benchmark 10-year local-currency bonds has surged 80 basis points since the plane crash to 9.5 per cent.
On July 25, Russia's central bank was forced to raise its benchmark interest rate by a further 50 basis points to 8 per cent - the third rate increase this year. Higher borrowing costs are the last thing Russia's ailing economy needs right now.
On July 24, the International Monetary Fund trimmed its forecast for Russian growth this year from 1.3 per cent to 0.2 per cent. The latest round of EU sanctions - accompanied by sectoral penalties imposed by the US government - will almost certainly tip Russia into recession in the second half of this year.
However, tougher sanctions are one thing. Getting Russia to abandon its support for the separatist rebels is quite another.
Putin has too much invested in this standoff - from a geopolitical standpoint and, just as importantly, a domestic political one - to be swayed by sanctions alone.
Indeed the perception on the part of most Russians that the West is now hell-bent on undermining their country's reputation and economy - reinforced by Monday's ruling by the Permanent Court of Arbitration in The Hague ordering the Russian state to pay the former shareholders of the defunct Yukos oil producer US$50 billion for the assets it expropriated from the company a decade ago - plays into Putin's hands.
Not only is Russia likely to retaliate against the latest sanctions - the country's parliament is now considering a proposal to ban the Big Four global accountancy firms and two of the world's largest management consultancies from operating in Russia - Putin has more of an incentive to intervene in Ukraine, because of the rising civilian death toll in the east of the country.
Tensions between the West and Russia - which have risen to cold war-era levels - are likely to escalate. Yet investors continue to shrug off these concerns and are far more sensitive to the conduct of United States monetary policy.
Emerging market equities rose 3 per cent in July, while the yield on JP Morgan's benchmark emerging market local currency government bond index has fallen to 6.5 per cent, down from 7.2 per cent in January.
Indeed, markets already seem to be taking comfort from the fact that the latest round of European sanctions exclude the gas sector and are designed to minimise the impact on European countries themselves.
The European Commission expects 0.3 percentage points to be shaved off the EU 's gross domestic product this year as a result of the new sanctions and the retaliatory measures Moscow is likely to introduce.
It's not just Russia's economy that is at risk.
Nicholas Spiro is managing director of Spiro Sovereign Strategy