Russia Sanctions: The Shock That Never Came

Summary

• US sanctions barring entities from participating in Russia’s primary debt markets are likely to have limited market impact. Sanctions were already fully priced and foreign holdings of OFZs have already dropped fairly significantly.
• Signs of de-escalation in US-Russia tensions are an important positive and further improvement lies ahead.

Market Implications

• The rouble is significantly undervalued and with Brent in the $60-$70/b range the currency has significant scope to appreciate.

US Treasury Announced Sanctions Against Russia

The most important measure announced on 15 April by the US Treasury bars US entities from newly issued local sovereign debt. The ban includes debt issued by the CBR, the Finance Ministry and the National Wealth Fund, effective from 14 June.

Apart from this, the Treasury included over a dozen individuals and 25 entities into the OFAC list. It cited their involvement in the attempts to influence the US 2020 elections and cooperation with Russia’s intelligence service, which it blames for the SolarWinds hack. Some of the newly targeted persons are sanctioned for asserting governmental authority in Crimea. Two companies are included in the OFAC list for their involvement in constructing the bridge over the Kerch Strait linking Crimea with the Russian mainland. Besides, Washington has expelled 10 Russian diplomats.

Ahead of the official announcement, The New York Times and The Washington Post published articles detailing the upcoming sanctions. The rouble weakened by more than 2% vs USD on Thursday morning but later regained some ground against the USD. Later in the day, OFAC clarified that American banks are not prohibited from trading OFZs in the secondary market (Interfax). The yield on 10yr OFZs, which peaked at 7.34% on 13 April, has tightened to below 7%. The rouble has already strengthened by more than 2% from its weakest levels.

Russia’s Fixed-income Markets Have Reacted Relatively Mildly

The main reason is that Russian asset prices have already fallen significantly since US President Joe Biden formed his administration earlier this year. The gradual build-up of US rhetoric has allowed the markets to fully price in the probability of the ban on investing in newly issued OFZs. This measure is viewed as less harsh than a ban on US persons to hold Russia’s local debt in circulation, which would have unleashed a new selloff in the OFZ market.

The recent data on non-resident OFZ holdings reflects intensifying outflows of investors’ funds in the weeks preceding the announcement (Chart 1). Last year, the share of foreign holders of local debt had already shrunk to ~23% from a peak of ~35% in February 2020. The non-resident share fell further to 20.2% last month. With rising US-Russia tensions, foreign investors were reluctant to participate in OFZ auctions. According to the CBR, they purchased only about 10% of newly issued OFZs at the March auctions.

The rise in OFZ yields across the curve over the last few weeks reflects both higher risk premia and the abrupt U-turn in monetary policy. At the previous CBR policy meeting in mid-March, the regulator surprised most market analysts by kick-starting its new tightening cycle with a 25bp rate hike. The CBR explained its decision to begin policy normalisation by citing the rise in pro-inflationary risks combined with a strong demand recovery.

The data released since the meeting vindicate the CBR’s decision to swing into a tightening mode.

CPI Accelerated in March

CPI edged up to 5.8% YoY in March vs 5.7% in February. Monthly inflation decreased slightly to 0.7% MoM vs 0.8% MoM. However, core inflation (which excludes one-off and seasonal factors) accelerated to 0.8% MoM vs 0.5% MoM and to 5.5% YoY vs 5.2% YoY.

Food prices decelerated to 0.8% MoM vs 1.2% MoM in February due to the administrative measures to curb price increases in specific food categories. In annual terms, food inflation decreased to 7.5% YoY after a peak of 7.7% YoY. Non-food prices accelerated somewhat to 0.7% MoM vs 0.6% MoM, and services prices rose by 0.4% MoM, roughly the same as in February.

The upward pressure on food prices decreased in the first two weeks of April, but evidence of new price pressures has emerged.

CBR’s bulletin Talking Trends portrays growing inflationary pressures. In addition to the food price shock, which helped inflation rise above the target in late 2020, other supply-side shocks are manifesting. The disruption caused by supply bottlenecks, higher global shipping costs and the shortages of key components (such as semiconductors) is already translating into price increases. Strengthening consumer demand allows businesses to transfer some of the rise in their input costs into prices. For example, sellers of both Russian-made and imported cars are rewriting their price tags.

CBR Will Consider Recent Market Selloff in Upcoming Policy Meeting

In late March, markets began to worry about ceasefire violations in Donbas and reports of Russia amassing troops in Crimea and on the border with Ukraine. The USD/RUB FX rate exceeded 77 earlier this month as investors saw the rising likelihood of a new military conflict in the region.

However, there are signs of de-escalation. Earlier this week, Biden called Russian President Vladimir Putin and proposed a summit. According to CNN, Biden told Putin that a new round of sanctions was coming during the call. On 15 April, speaking in the White House, Biden announced that the US was ready for constructive dialogue with Russia in the areas where cooperation would benefit the US. He called his conversation with Putin ‘respectful’. According to Biden, he told the Russian president that he could have imposed harsher sanctions but decided against it.

There is a further sign of de-escalation. The US has withdrawn its request to Turkey to allow US military ships to pass through the Bosphorus into the Black Sea, logged a few days before. The US Navy’s presence in the Black Sea would be a significant irritant for Russia, which recently moved more ships to the Black and Azov seas.

Russian Markets Should View Biden’s Conciliatory Tone as Good News

Until yesterday, the Biden administration faced firm pressure from a bipartisan consensus in the US Congress that Russia required punishing for its recent transgressions.

The fresh sanctions announced yesterday ticked all the boxes: they addressed Russia’s attempts to influence the outcome of the 2020 US presidential elections and the GRU’s role in the SolarWinds affair. The measures targeting Crimean officials and Russian companies involved in building infrastructure in the peninsula aim to alleviate Ukraine’s concerns. Meanwhile, The Financial Times reports that due to insufficient evidence the administration had decided against imposing sanctions for Russia’s alleged offering of rewards to the Taliban for killing American troops in Afghanistan.

Biden’s stance offers Russia a real chance to de-escalate Ukraine tensions quietly while saving face. I do not see why the Russian leadership would want a new military conflict with Ukraine right now. Russia has already given Ukraine a strong signal that it could move its troops into the conflict zone if Ukraine tried to re-establish control over it.

In theory, the US could impose more sanctions against Russia for the use of chemical weapons to poison Alexei Navalny. However, the likelihood of this seems diminished. It would complicate US efforts to involve Russia in the dialogue on issues like climate change, the containment of Iran’s nuclear programme and the reconciliation process in Afghanistan.

Rouble Rally Could Continue

If I am right and the current tensions subside in coming weeks, there are reasons for the rouble rally to continue. With the Brent oil price in the middle of the $60-70/bbl range, the rouble is still significantly undervalued.

Returning to the CBR policy decision on April 23, I expect the regulator to maintain the pace of policy tightening at 25bps and hike its policy rate to 4.75%. Most importantly, the new US sanctions announcement did not cause high volatility on the rouble market. Notably, CBR officials have not issued any particularly hawkish statements recently that would point to the high likelihood of a 50bp rate hike.