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Ukraine: Russia and NATO's war of words escalates

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A match appeared to have been struck to the smouldering tinder of the conflict in Ukraine this week, with both Russia and NATO accusing the other of interference in the country.

Russia's Foreign Ministry warned of the possibility of "civil war" if "military preparations" by Ukraine did not stop.

Late Tuesday, the Ukrainian security service issued a statement saying a group of separatists had placed explosives in a seized building in the eastern city of Luhansk and were holding about 60 people against their will.

Earlier Tuesday, around 70 people were arrested in eastern city Kharkiv after protesters in favor of a Crimea-style annexation by Russia stormed government buildings. This followed the escalation of pro-Russian protests, which some in Ukraine allege are backed by the Russian government, in recent days.

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These actions add to fears that the Russian government may intervene directly in its struggling neighbor, which would lead to further economically-damaging sanctions from the Western governments.

"If Russia were to intervene further in Ukraine it would be a historic mistake," NATO secretary-general Anders Fogh Rasmussen told a news conference in Paris.

"It would have grave consequences for our relationship with Russia and would further isolate Russia internationally."

Russia countered with accusations that U.S. mercenaries had been operating in Ukraine, while wearing the uniforms of Ukraine's Sokol, its special forces.

"The biggest concern on the ground is, if we start seeing fatalities, particularly of Russian protestors, does that give Putin an excuse to lead a further invasion?" Raoul Ruparel, head of economic research at Open Europe, told CNBC.

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Investors are increasingly wary of both countries as a result. Russian 10 year bond yields dropped slightly to 8.99 percent in early trading Tuesday, after rising Monday as tensions escalated. The price of gold hit $1,309 as investors looked for safe havens.

On the other hand, U.S. Secretary of State John Kerry is organizing a meeting between diplomats from Russia, Ukraine and the European Union in the next ten days to try and kickstart dialogue, which could increase the likelihood of a peaceful solution to the crisis.

Sergei Lavrov, Putin's foreign minister wrote in a Guardian piece: "It is time to stop the groundless whipping-up of tension, and to return to serious common work." This may suggest some willingness to step back from the edge of the cliff leading to further conflict.

The situation could "literally go in any direction," according to Tim Ash, head of emerging markets research at Standard Bank.

There are also worries that these troubles will distract from the need to rebuild Ukraine's struggling economy, and influence the elections on May 25. The current caretaker government was cobbled together following the collapse of the previous regime, but is open to attacks on its legitimacy by Russia because it has not been democratically elected.

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"Through its actions Russia appears intent on undermining the new Turchynov/Yatseniuk administration in Kyiv, and creating instability in the run up to the May 25 presidential elections. This makes implementation of economic policies as per the soon to be finalized IMF agreement that much more difficult, nigh on impossible," he added.

The current protests are still relatively small, suggesting that there is less support for independence than there was in Crimea. There is a risk for the Ukrainian authorities that using military force against the demonstrators will be seen as a reason for Russia to intervene directly – and possibly even threaten the sovereignty of the entire country.

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"The worst fears of the West about Ukraine are being confirmed," Nicholas Spiro, managing director of Spiro Sovereign Strategy, told CNBC.

"Not only does Russia refuse to back down, it is raising the stakes further by sowing tensions and destabilising parts of eastern Ukraine in an effort to ensure the country is not drawn into the Western fold."