What’s the End Game for the Chinese Yuan?

Originially posted at Agilityforex.com

After a brutal sell-off in February of this year, the Chinese Yuan has slowly gained back about half of the ground it lost in the People’s Bank of China engineered bloodbath, where the currency had its largest short-term decline in years. The free-fall came in conjunction with the Chinese government widening the trading band by two percent as they follow the path to making the Yuan a free floating reserve currency. At the time, markets were worried that the Chinese were weakening the Renminbi in order to stimulate growth. Although still in high single digits, the Chinese economy has weakened significantly from its glory days of ten percent plus expansions annually. However, in hindsight, it seems that these fears were groundless. Looking backwards, the spike in USD against CNY earlier in the year was most likely an attempt to reduce one sided short-dollar carry trade bets.

There have been costs to Chinese corporations associated with the Central Bank’s intervention. Many of the companies were borrowing offshore in dollars and paying in Yuan, taking the view that the Renminbi would forever strengthen. The move in the currency obviously went against this view. This caused significant losses to Chinese corporate balance sheets. Perhaps the slow appreciation since the peak of the decline in March is an attempt to help repair these paper losses. In any case, the point has been made-don’t make one-way bets with the Chinese currency or you might get burned.

The real question is where does the Yuan go long term? How should you position your portfolio relative to China? Can you make money still with a Yuan pair trade? To answer these questions, investors need to have an understanding of the history of the currency and an appreciation of the government’s goals regarding the Renminbi. It is in China’s best interest to eventually have a free floating Yuan to promote use as a global trading and reserve currency. This outcome will only foster economic stability in the Middle Kingdom. The Chinese Communist Party leadership has been remarkably patient and determined in moving their economy towards a capitalist system that will rival America’s economy. They realize that reserve currency status will give them the margin of error and currency hegemony that the United States currently enjoys with the USD. The Chinese envy this status. So seen in this light, widening the trading band of the currency is an attempt to push the status of the currency forward and to wring corruption out of the system. This goal is admirable.

However, the Chinese government also realizes its export oriented economic model cannot last forever. The Chinese population are becoming wealthier and expectations for the good life are rising. Other Asian nations are becoming more competitive as far as labour costs are concerned. China cannot be the low cost producer forever. In this light, the Party is pushing the shift to a domestic consumption oriented model. A stronger currency supports this effort. China is also very dependent on imports of raw materials. A strong Yuan helps this situation as well. The government realizes that no nation, in the long-run, has ever devalued its way to stable prosperity.

So what are investors to do? Is the Yuan at these levels a buying opportunity? Or is the currency becoming too volatile. In my opinion, the Yuan will continue to appreciate over time, although there will be much more short-term volatility. Investors should take a partial position at these levels against the dollar and keep some powder dry to add size on the dips. That being said, I don’t believe the Yuan is still a short term trade. The central bank intervention has seen to that. I think this is a longer term bet that could take time to materialize. In that vein, if you have capital to put to work over the medium term, consider taking a bite of Yuan.

 

L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt. He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV. LToddWood.com

Ukraine’s Economy Held Hostage to War

Originally posted in The Moscow Times

Despite winning closer relations with the EU, many Ukrainians are losing faith in the Maidan revolution as war rages in eastern Ukraine. Their future is dependent on the duration and outcome of a civil war, that, no matter its conclusion, has already significantly damaged the country’s economy.

Ukraine already had serious economic problems even without having to deal with separatists in its east. This year economic growth in Ukraine is estimated to shrink by more than five percent. The country faces a short-term debt service hurdle of more than $30 billion, which could be met with help from the International Monetary Fund and the EU, but only on the condition of stringent reforms.

While other Eastern European countries have thrived, Ukraine’s economy is smaller now than it was when she gained her independence more than twenty years ago. This is primarily due to corruption and energy inefficiency. Unscrupulous and powerful interests siphon off billions in revenue every year and the Ukrainian people suffer the consequences.

Ukraine has made some progress recently by reducing energy subsidies and taming its Central Bank’s penchant for currency manipulation. However, patience is running thin, and the new president’s honeymoon period will not last long.

Not long ago I spent some time in Kiev and other areas of Ukraine, talking to citizens about their experiences. “We all had such high expectations. Now we now realize, whatever happens, it is going to take a long time to for things to get better for us, even if we partner with the European Union,” one young man complained. “People just want jobs. And there are none.” The cessation of hostilities is paramount to economic recovery. With the ending of the cease-fire and the active targeting of pro-Russian separatist groups in the East, it seems Poroshenko has decided that the only way to control the situation is to defeat the rebels. This could just be a negotiating tactic; a way to apply pressure for a better settlement with Russia on their many economic differences, most significantly over the price of Russian gas. But in the meantime, the Ukrainian people are suffering both a reduced standard of living and a civil war as well. Nor is the suffering necessarily isolated to eastern Ukraine. Many living in Western Ukraine are from Luhansk or Donetsk and still have family there. “I fear for my parents. They cannot leave” said one acquaintance in Kiev.

Another serious issue for Ukraine is that most of the heavy industry in the country, including the mining, mineral and industrial sectors, is located in the east. The industrial sector in particular is reliant on the Russian military and other heavy industries for business. Without peace in the region, economic stability and growth seem a like a pipe dream.

My last morning in Kiev, I sat at a local cafe and enjoyed coffee with a young Ukrainian girl and her English fiance. “We are here to obtain our fiancee visa,” she said. “Are you going to stay in Ukraine?” I asked them. “No,” they replied. “We are moving to the U.S. I’m looking forward to North Carolina,” she said forcefully.

The USD Show’s Not Over But The Fat Lady’s Warming Up

Originally posted at Fox Business

It is not hard to underestimate the animosity felt towards the international trade payment system that is based on the historical role in recent history of the United States dollar as the global reserve currency.  Adversaries of the United States have a love-hate relationship with the USD.  During the recent Ukrainian crisis and the short-lived sell-off of the RUB against world currencies, Russians flocked to the USD as a haven, even demanding to settle real estate transactions in USD for a short period.  However, the need to use dollars to settle trade and other transactions has government and business leaders seething, especially with the imposition of economic sanctions by the West.

 

The Bretton-Woods agreement towards the end of World War II created a system where global currencies were linked to the USD, which in turn was backed by gold.  However, costly global wars and an irresponsible spending spree for the welfare state or Great Society forced Nixon to abandon the gold standard in the early 1970s.  The out-of-control spending has continued unabated by either party in power.  The sovereign debt of the United States is approaching twenty trillion dollars with no end in sight.  The situation has only gotten worse and the market is beginning to lose faith in the will or capability of the United States to make good on its financial obligations to its creditors.  

 

The emotions of fear and resentment are working hand-in-hand against the USD to remove its status as the global reserve currency.  On one hand hand you have resentment against the financial hegemony the United States currently enjoys.  The use of the dollar as a trading currency around the world gives the U.S. enormous advantages that are not well understood by our reckless politicians.  There is a natural bid, or demand for the dollar as it is used to settle accounts and trade transactions.  This puts a floor under the value of the currency as countries and businesses need dollars to conduct business.  This is why the announcement this week that Russia and China would work to exclude the dollar from their bilateral trade is so important.  The two countries will settle their transactions in their own currencies of RUB or CNY.  It is not that this initial step will jerk the valuation floor out from under the dollar.  The point is that this is one of the first steps in removing a reason to own dollars.  The consequences will be felt not immediately but years down the road as this process continues.  Other nations will follow on this path and our children will suffer the consequences.

 

On the other hand, we have a federal government that cannot and has no desire to stop spending money the United States doesn’t have.  Today President Obama announced executive action to basically provide a way for students to default on a majority of debt owed on student loans.  The President said, “When deciding between paying for student loans or tax breaks for millionaires, this should be a no-brainer.”  I think his statement should be rephrased.  He should have said, “When deciding between transferring liabilities from possible voters to the federal government or the taxpayer, I’ll pick the possible voters every time.”  This executive action is stunning in its scope.  Trillions more in debt will be added to the federal ledger along with Obamacare and everything else.  The results are simply disastrous and the path is unsustainable.  This is where the other emotion of fear comes in concerning the dollar.  How can any reasonable person see the political will or ability of the United States to pay back the money an investor has loaned them?  Of course bond buyers and other entities long dollars will look for other options to preserve their wealth.  It is obvious the dollar will lose its reputation as a store of value if it hasn’t already.  It’s only a matter of time.  


We should expect to see other countries work to exclude the USD from their trade settlement procedures.  We should expect to see other currencies or commodities rise to become a safe haven in the midst of all of the this financial recklessness.  I haven’t even begun to discuss the Federal Reserve printing dollars like junk mail and turning the currency into Monopoly money.  Maybe the fat lady has begun to sing after all.

How Ukraine Will Affect The Euro Debt Crisis

Originally Posted At Fox Business

There has been much written and discussed about the current situation in Ukraine and how the ensuing sanctions could affect the Russian, Ukrainian, and European economies.  A European study was leaked to the press recently that showed almost 1% of GDP could be shaved from Germany if Europe restricts Russian gas imports and levies level three sanctions, which could also include restrictions on other sectors.  

Yes, sanctions will hurt all involved; however, the real issue is how this geopolitical conflict and tension, due to events in Ukraine, could impact Europe’s exit from the 2008 debt crisis.  Europe is far from being out of the woods on this issue.

The reality is that countries like Greece are still hurting badly from the crisis and the ensuing austerity imposed by the Troika, or the ECB, IMF, and EU.  Although Greece recently tapped the bond market for the first time in several years, the underlying fundamentals of the economy are still quite fragile.  

The southern, peripheral economies of the European Monetary Union are very afraid of the economic consequences of sanctions on Russia and vice versa.  Level three sanctions which boycott large sectors of the Russian economy will bring only more pain to these financially insolvent nations.  The economic damage could negate any positive benefits that have been created by the ECB getting involved in the bond market and purchasing sovereign debt, or printing money. 

At any rate, a deeper conflict in Eastern Europe would almost ensure the ECB will ramp up another round of QE; they have already been making noises that this intervention is being considered.  This action would dig Europe’s financial hole even deeper.  At some point, as in the U.S., all of this money has to be taken out of the economy. 

At its core, the crisis in Ukraine has highlighted an even greater truth in geopolitical strategy.  Machiavelli famously said, “It’s better to be feared than loved.”  The conflict has reiterated the historical truth that economic weakness leads to military weakness.  

Due to the high cost of the European welfare state, Europe has neglected its regional security for too long.  It has become dependent on the United States for its protection and now America is economically weak as well.  The Kremlin is sitting on over half a trillion dollars in foreign currency reserves and has almost no debt.  Yes, sanctions will have an effect on their economy and standard of living, but they have several years to reorganize their customer base and turn to the East to sell gas.  Europe and America no longer have a safety net.  History repeats itself and now the fruits of the West’s financial mismanagement have come full circle.

It remains to be seen whether Europe can even come to an agreement on sanctions if Putin decides to destabilize the May 25th elections in Ukraine.  If they cannot stand up to the face of Russian aggression, Europe is finished as a political force.  This could further weaken the region’s economy as confidence in the Euro will be undermined as well.  Confidence in NATO will also be damaged. 

The decades of Western fiscal neglect and living beyond its means has led to the current security problem for Europe.  Now the piper has to be paid; the bill is due.  The West must deal with its fiscal insolvency once and for all and live through the pain that will definitely ensue.  There will be further economic suffering, due to the crisis in Ukraine, for all involved.  

The alternative to dealing with the problem is to see Europe, NATO, and the West in general fall into further decline that may be irreversible.  Russian president Putin is famous for playing the long game.  He sees the weakness emanating from Europe and the United States as well.  Perhaps he will just bide his time and wait for the self-imposed economic crisis in the West to deepen and he will have further attempts at a bite at the apple.

Risk Off! Time To Protect Your Portfolio From Geopolitical Events

Originally Posted At Fox Business…

 

As I sit here in Kiev, Ukraine, and see the chaos enveloping the world around me, I think it’s time to pound the table for investors to protect their portfolios.  American leadership is absent, other world powers are rising, and geopolitical tensions are reaching the breaking point.  Not to mention, the stock market is at all-time highs and the VIX is bouncing off traditional lows. 

If there ever were a time when complacency ruled the day in the face of gargantuan threats over the horizon, now is that time.  I know the old Wall Street saying about climbing the wall of worry in the face of uncertainty, but I believe it pays to be prudent at this market juncture. 

Let’s start with the situation in Ukraine.  It is obvious that the Russian president is hell bent on recreating not necessarily the former Soviet Union but rather the old imperial Russian empire.  The West seems unable to deal with this fact.  The end game is that the violence, unrest, and tensions between the Russian Federation, their Ukrainian supporters, and NATO will reach levels that most investors cannot yet comprehend.  This conflict will have negative reach into European markets and therefore globally.  This no- hot shooting war could manifest itself in reduced natural gas supplies to Europe and lead to contraction of the leading Western European economies. 

At a minimum, Europe will have to spend more on defense at a time when deficits are still raging across the continent.  We could even see the conflict move into the Baltic states who are now members of the North Atlantic Treaty Alliance.  Then, all bets are off as then we could be seeing World War III. 

The Obama administration has been touting a recent shift in American defense policy to Asia.  This seems premature at best and likely incompetent at worst.  But what have been the results of this policy?  China is rising and starting to flex her muscles garnered from a decade of increased defense spending as the Chinese economy overtakes the U.S.  Japan is starting to talk of rearming and growing its defense establishment in order to counter the new Chinese threat.  American Defense Secretary, Chuck Hagel, was recently given a tour of the new Chinese aircraft carrier as China strives to build a blue water navy to counter the United States globally.  North Korea is openly threatening our Asian allies with nuclear war and has even mentioned the western coast of the United States as it builds its ICBM capability. 

I haven’t even begun to discuss the multiple flash points in the Middle East.  Iran is hell bent on developing nuclear weapons and openly threatens Israel, who will have to act on her own in self defense at some point.  Syria continues to be a flash point.  Iraq and Afghanistan are disintegrating into lawlessness again as America withdraws from the world stage. 

All of the examples are reasons why investors, in my opinion, should reduce risk in their portfolio.  One can look at buying insurance through derivatives, looking for short-term yield opportunities, reducing equity exposure, adding precious metals as historical stores of value, and even just going to a larger percentage of cash.  The trick here is to be patient and wait for an opportunity to buy what you want when it goes on sale as there will definitely be an opportunity as some point in the near to medium term.  I know that typically it is very hard to time the market and most are not successful, but I believe the risk/reward ratio at this point in time on the geopolitical scene calls for risk off!

Don’t Reach for Yield - Take the Easy Dividends and Option Premium

Originally posted at Fox Busness

Yield oriented investors have had a tough time since the financial crisis in 2008.  The old adage, “Don’t fight the Fed,” has rung true as the central bank intervened in the bond market to keep interest rates artificially low.  In order to prop up the economy and allow the United States to service its skyrocketing sovereign debt, the Fed has been actively buying U.S. Treasuries and mortgage bonds, ballooning its balance sheet and destroying savings rates for investors.  

So where is an investor to go for yield when rates are so low and there is abundant interest rate risk in the bond market?  If he stays short he is paid next to nothing and if he extends duration, he is taking on risk that his principal value will fall significantly when rates rise eventually.  I can remember very well when I entered the business in 1994 when investors in “safe” bond funds lost thirty percent in a very short period of time.  If the investor goes down in credit quality for yield, his credit risk increases as well.  Bonds in this environment are usually cheap for a reason.  I say stay out of the bond market all-together.  There is no value there.  Instead, look to equities and collect dividends.  Run a screen and  look for the highest yielding large-cap, blue-chip companies; that is where you can find income in this environment.  If their yield is high, that means the stock price is possibly depressed for some reason.  An investor can collect 2-4% dividends on very high quality companies compared to savings rates of near zero.  Also try and find a stock chart that shows a sell-off and then a long period of building a base.  This means the stock very likely has found a near-term bottom.

At the same time, investors can further increase their income, while decreasing risk, by selling covered calls on these blue-chip equity positions.  By selling the option that the stock could be called away from you at a higher price, you collect a premium.  With the market hitting all time highs and the volatility index at very low levels, it is probably a good bet that you will not be called away any time soon as the equity market is most likely topping out at some time in the near future.  If the equity markets sell off, you have limited your risk by buying undervalued stocks, collecting a nice dividend and additional call premium.  If the markets rally and you are called away on your position at a higher level, the worst thing that can happen is you have bought low, sold high, collected dividends and an option premium.  That’s better than a sharp stick in the eye!  Finally, buy several equity positions to further diversify your risk; somewhere between ten and fifteen positions is perfect.  

The bottom line is that if you are on a fixed income or an investor that has expenditures he has to match to cash flows, there are other options in these markets besides buying fixed income that offers very low yield and comes with a ton of interest rate risk as well.  The combination of high-yielding, blue-chip equities and collecting option premium through selling covered calls, can provide a much higher level of cash flow.  This strategy doesn’t come without risk as equity markets definitely have a downside; however, you can minimize that risk by buying out of favor companies and selling options to give yourself a cushion.  Interest rates only go from twenty percent to zero once in a lifetime.  With rates close to zero, the only way to go is up and your principal is at risk.  As they say on Wall Street, “Interest rates are low until they’re not.”

One Way To Pressure Russia

Originally published in The Moscow Times

The Obama administration’s decision to release 5 million barrels of crude oil from the U.S. Strategic Petroleum Reserve on March 12 signaled to Russia and the rest of the world how the West intends to respond to the Kremlin’s actions in Crimea. It is a harbinger of things to come.

One of the weaknesses that the West has chosen to exploit is Russia’s dependence on energy exports. No matter what you think of the situation in Ukraine, the new global energy realities need to be understood.

The U.S. Strategic Petroleum Reserve was set up after the Arab oil embargo of the 1970s and holds about 727 million barrels of crude oil, making it the largest reserve in the world.

The White House described the March 12 release as a “test release.” However, the timing was not coincidental. It was a shot across the bow of Russia’s petroleum based economy.

The global tension caused by events in Ukraine have actually added to the Russian coffers as the price of crude oil has risen while the ruble has been devalued. By releasing oil from its strategic reserve, the U.S. is telling the world that it has the power to influence the world oil market if it so chooses, and the timing indicates that it considering this course of action in response to events in Crimea.

The Strategic Petroleum Reserve is not the only arrow in Obama’s quiver. For example, he could use his executive authority to waive the 1970 ban on U.S. crude oil exports — the same act of Congress that began stockpiling crude oil. In this way, the U.S. could instantly drop millions of barrels of oil on to the international market. In fact, U.S. refineries cannot handle any more of the light sweet crude being produced in shale regions than they are already processing.

U.S. refineries are geared toward the more heavy oil imported from Venezuela and elsewhere. So, by exporting surplus crude to European refineries, the U.S. could reduce European reliance on Russian crude.

Finally, the U.S. can hit Russia through the natural gas market. The hydraulic fracturing revolution is turning the U.S. in to a net exporter of natural gas. Over the next few years, the U.S. and Europe are expected to expand their liquified natural gas infrastructure, further reducing the European market for Russian gas. In less than five years, the threat of a Russian gas cutoff could ring hollow.

Sure, Russia has the largest reserves of hydrocarbons in the world, but it does not possess the technology to harvest them on its own.

It needs Western support and extraction technology to efficiently develop Russian hydraulic fracturing capability in the north. The West could embargo this technology to slow the growth of this capability.

Additionally, a number of European nations have already started to break away from the global warming craze and develop their own hydraulic fracturing sector. This will further reduce demand for Russian gas.

How would these measures effect Russia?

The hydrocarbon windfalls of the last decade have not led to a modernization of the Russian economy, which would have reduced its dependency on energy exports.

Russian government revenues and consumption remain highly dependent on the oil prices. If the U.S. floods the market with crude, the global price of oil will fall and negatively affect the Russian economy. This might push the economy into a recession and the federal budget into a deficit spending situation.

Meanwhile, Russian borrowing costs on the capital markets have been rising. Russia does have a large foreign currency reserve to cushion the blow, but it will not last forever. These reserves must also be used to defend the ruble against its almost certain devaluation.

The discovery of vast hydrocarbon reserves in the U.S. and elsewhere in the last decade has dramatically altered the geopolitical chessboard and the balance of power in the global energy market.

The recent release of oil from the U.S. Strategic Petroleum Reserves is the first of many validations of this new world order. Russia should take heed of these new realities.

Economic Weakness Creates Military Weakness

Originally posted at Zero Hedge

It has happened over and over again throughout history.  Nations, empires, and dynasties have made bad economic decisions which lead to their own destruction.  The scenario usually goes something like this—one generation sacrifices and works hard to overcome global challenges and creates an economic powerhouse, which in turn allows it to project military power.  Follow on generations take their elders work for granted and ignore and even denigrate the fruits of hard labor, they just want the benefits and start giving away the spoils for free.  The next generation indulges itself in sloth and corruption and is overrun by the barbarians. 

The Roman Empire was famous for giving out bread and circuses to satiate the citizens of Rome, all the while devaluing their currency with less and less precious metal.  They ignored their financial obligations to their military.  The Emperor became corrupt, handing out favors only to those closest to him and persecuting the opposition while ignoring the very real threats to the north until it was too late.  The Spanish also devalued their currency by reducing the precious metal content as they fought wars all over the world.  We all know how that turned out.  After WWI, the Deutschmark to the Dollar exchange rate was 4 to 1.  In order to pay their war reparations, the Weimar Republic started printing money.  A few short years later it was four million to one USD.  This destroyed the German economy and gave Hitler an opening to power. 

Today with convoys of Russian troops rolling through the Crimean Peninsula and Hind helicopter gunships controlling the skies, one doesn’t have to look far to see evidence of American weakness.  Whether or not you can understand the Russian position, the bottom line is that Putin does not fear a Western reaction to Russia projecting power in Ukraine.  This situation is the latest in a long list of examples of American economic weakness leading to serious national security threats.  Iran continuing to develop nuclear weapons, Syria defying the Russian brokered agreement to destroy its chemical weapons, Russia granting Snowden asylum, North Korea going nuclear, China threatening Japan, are a direct result of an absence of a serious American response or perceived threat.

Why is America no longer credible when our president draws a red line or two or three?  It is not just that Obama is a weak leader and naive in foreign affairs, although that is certainly true. It is because American owes $17 trillion dollars, a good chunk of  it to our adversaries.   It is because we are cutting the meat from our defense budget in order to fund bread and circuses to keep the people happy.  It is because pilots in the Air Force are flying the same tail numbers their grandfathers did.  The U.S. military used to train and equip to fight two wars simultaneously.  Now the world knows America is broke and cannot even sustain one long term conflict financially.  This status of affairs has not just happened under Obama.  A long list of Democratic and Republican administrations have not spent our money wisely.  And our allies in Europe are in no better shape.  In fact, their defense situation is worse after decades of relying on the Americans and running up their debt to GDP ratio as well. 

At some point, the FED will lose control of the bond market no matter how much money they print.  Then interest rates will be set based on the credit risk of the United States.  This will cause interest rates to shoot higher.  Each percent rise in interest rates is approximately $200 billion in increased debt service costs for the United States.  Soon the majority of the federal budget will go to paying interest and entitlements and defense will be squeezed even harder.  We have not even begun to see austerity yet.  This interest rate shock will also hurt the economy.  Do you remember the twenty percent mortgage rates in the seventies?  Federal revenue will shrink at the same time expenses are rising.  The future is not pretty.

America only has a short time to deal with this problem.  We need to stop spending money we don’t have and we need to grow the economy.  The government needs to get out the way.  If you are in a hole and want to get out the first thing you need to do is stop digging.

It is not our generation that will suffer.  It will be your children and grandchildren.  Do you hear that commotion to the north?  The barbarians are coming.

The Hydraulic Fracturing of Saudi Arabia

Since the early twentieth century, Saudi Arabia has had a close relationship with the United States. From the development of the Saudi oil fields, to the First Gulf War, this relationship has been an uneasy cooperation—each side received something out of the alliance while nervously watching the other. 

So now we have the first open break between the two powers culminating in the Saudi’s refusing a seat on the U.N Security Council due to anger with U.S. Middle Eastern policies. 

Saudi Arabia holds the world’s second largest oil reserves and the sixth largest natural gas fields.  In addition to being located in the most volatile part of the world, these energy assets make the country a strategic interest for any global power. 

The discovery of vast hydrocarbon reserves in the United States and the ability to harvest them through hydraulic fracturing techniques has radically altered the relationship between the two countries.  Ironically, even though the Obama administration has reduced drilling on Federal lands in the US and attempted to curtail hydrocarbon use overall, it is fracking which has allowed the United States to nearly gain energy independence, become a net energy exporter again, and reduced our need to buy oil from the Middle East.  This shift in the balance of power with the Saudis has made the Kingdom extremely nervous. 

American policy adds to the Saudi’s concerns.  Their oil fields, located in the eastern part of the country, are the home to the country’s Shia minority.  As the guardians of the holy Muslim sites, the royal family walks a fine line between satisfying the Sunni Ulema, fighting terrorism, and keeping the Shia population in check.  Hence, their concern with America’s recent overtures to Iran. 

The Obama administration seems Hell bent to secure a deal with the Shia Islamist state regarding its development of nuclear weapons.  The Saudis, along with the Israelis and other Gulf states, cannot tolerate a nuclear armed Iran.  There are rumors that Saudi Arabia has paid Pakistan for the development of its own nuclear deterrent and is one month away from operational capability if they saw fit. 

In addition, they are furious with the U.S. refusal to arm Sunni rebels fighting the Iranian backed Syrian regime.  The uneasy trust between the U.S. and Saudi Arabia has been broken.  This opens up the playing field for other global powers such a China or Russia to make inroads where the U.S. once enjoyed hegemony.  It also opens up the world to a possible nuclear arms race in the Middle East.  In fact, this is already happening in Egypt, another broken U.S. relationship, who just closed a major arms deal with Russia in a slap in the face to the Obama Administration’s decision to cut military aid.  China would like nothing better than to gain access to a secure source of Saudi oil and strategic American built bases as well.

There have been calls from many quarters for the U.S. to mend fences with Iran in order prevent conflict and counter the Sunni influence in the region.  It seems obvious that for this to happen, Iran needs to show real progress in addressing the world’s fear that they intend on acquiring the bomb and have plans to use this threat to destroy Israel and/or the interests of the United States. 

It is foolish for America to offend and promote distrust with another ally in a long list of broken long-standing relationships.  These include Poland, United Kingdom, Israel, Egypt, etc.  One wonders whether the results of American diplomacy  stems from extreme incompetence or is evidence of a much darker agenda.

Are We Fighting the Last War?

After World War I, the French built the Maginot Line on Germany’s border to guard against, and repel any German Army incursion into the homeland. Unfortunately for the French, they prepared for the defensive trench warfare that characterized WWI, and were caught flatfooted by the Blitzkrieg tactics of the new German Army, and were subsequently overrun in a matter of days by the powerful mobile army.

As an Air Force Academy grad, it was drilled into me during PMT or Professional Military Studies—that historically militaries fight the last war.  In other words, they train and equip to fight the last conflict they were involved in, while overlooking threats on the horizon—it’s a familiar, natural impulse.  And it’s troublesome.  The US military is on a path of committing this strategic error.

Since 9/11 the United States has fought two low-intensity conflicts.  Special operations forces have been front and center.  It is a vital and necessary part of our defense structure to be able to respond to unconventional threats in an unconventional manner.   

However, it is likely that the next conflict could be global and conventional in nature.  We are not prepared for this scenario.

The majority of our current bomber force started production in 1952, hence the B-52 designation.  We are still flying the H model, which was the last variant of 744 bombers produced and was fielded in 1962.  Yes, it has been modified and modernized, but the airframe is absolutely ancient by military standards.  The Air Force has about 20 B-2s, which cost about a $1 billion each, and are designed with decades old stealth technology.  The approximately 60 B-1s still in service were cancelled by Jimmy Carter and resurrected under Reagan’s defense build-up.  They also rely on an obsolete design.  The youngest of the crowd is the B-2 and even that is over twenty years old.  We have pilots flying the same tail numbers their grandfathers did. 

The fundamental purpose of air power is to precisely deliver ordinance on a target in a devastatingly effective way.  That’s what bombers do.  In a drawn-out global conflict with reasonable estimates of attrition, these one hundred and eighty aircraft are in danger of being decimated in a period of weeks or months.  Even small, rogue nations today have state of the art anti-aircraft technology, which could potentially wipe out our bomber capabilities and advantage. 

So let’s turn to the Navy.  Currently, the US Navy has less than three hundred combat ships.  Yes, these vessels can do the job that required multiple ships in the past and they are very powerful, but they are still only three hundred ships.  In asymmetric warfare, the enemy will employ tactics to use this concentration of power in a small number of ships against us.  Our adversaries, such as China, have developed very capable anti-ship missiles.  We can defend ourselves against the missile threat up to a certain point through advanced technology.  However, they can destroy our ships if they have enough of them.  And they can do it at a much cheaper cost than building a blue water fleet of their own.

As for our land forces, we are currently in the middle of a force reduction of approximately eighty thousand soldiers for the U.S. Army and around twenty thousand for the Marines.  There are additional cuts to come due to sequester.  The United States gave up several years ago the capability to fight and win two conflicts at once around the globe.  Soon, we simply will not have a large enough force structure to fight one.

Yes we have the greatest military in the world.  And it is true that no one can challenge our Air Force or Navy in the sky or on the seas.  That is, not yet. 

The fiscal pressures our country faces have brought about this diminution in military capability.  There is no end in sight to the reduction in expenditures for the Pentagon.  Of course there is waste to be cut in the Department of Defense.  However, we have to be careful not to impede the modernization of our conventional forces.  The United States also has to be careful to not allow hyper expensive weapon systems pushed by industry to crowd out the procurement of less expensive, capable, survivable armaments in larger numbers.  We are dangerously close to being unable to sustain a large scale, drawn out, global conflict.

The best war is the one not fought.  If our potential military adversaries perceive us as weak, that is an invitation to war.  If we continue to de-emphasize our conventional forces, we will invite this disaster.