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Washington’s so-called allies continue to gravitate towards the Russian sphere of influence, and specifically the Russian S-400 Triumph advanced anti-aircraft weapon system.

First it was Turkey, which openly defied Trump’s threats that the US would sanction Ankara if it completes the purchase of the anti-aircraft missiles, saying the acquisition of the missile defense system is “a done deal and Turkey will not turn back from its decision.”

Now India is also moving towards acquiring five or more S-400 from Russia despite the threat of US retaliation. The Defense Acquisitions Council (DAC), chaired by minister Nirmala Sitharaman, last week approved the “minor deviations” in the $5.7 billion deal to purchase S-400s for final government approval, to the finance ministry and the Prime Minister’s office sources told the Times of India.

The DAC discussed the S-400 deal just one day after Washington on Wednesday canceled a “two-plus-two” discussion involving foreign minister Sushma Swaraj and defense minister Sitharaman and Washington officials Mike Pompeo and Jim Mattis, which was scheduled for July 6.

The Times of India noted that in October 2015, India had planned to procure the S-400s – which can detect, track and destroy supersonic bombers, drones, fifth-generation fighters, spy planes, and supersonic missiles at a range of up to 400km and altitude of 30km – in what many Indian officials have praised as a game-changing military acquisition.

The world’s leading Ballistic Missile Defense (BMD) systems are Patriot Advanced Capability-3, THAAD, S-400 Triumph and S-500. India has big ambitions for regional dominance and has been attempting to develop a domestic BMD system over the last several decades.

And while Washington officials briefed India on the use of Patriot system, it seems that the country is more interesting in purchasing Russian made BMDs instead.  The New York Times reported in April that the Indian/Russian deal serves as a blow to the United States’ ”struggling Patriot missile defense system.”

“India wasn’t very impressed with the Patriot compared with the S-400, which wins hands-down in capability, in its availability, service availability. It’s a more efficient system,” it cited Rahul Bedi of Jane’s Information Group as saying.

Petr Topychkanov, a senior researcher at the Carnegie Moscow Centre’s Non-Proliferation Programme, says “despite heavy investments in developing anti-ballistic missile systems, India may not be able to fully defend itself in a conflict from strikes by Pakistani missiles.”

India and Russia have worked on a plan to beat the financial sanctions called CAATSA (Countering America’s Adversaries through Sanctions Act) that attempts to prevent countries from purchasing Russian weapons.

“The acquisition of this technology will limit, I am afraid, the degree with which the United States will feel comfortable in bringing additional technology into whatever country we are talking about,” US armed services committee chairman Mac Thornberry said back in May, noting that there is also concern that “any country that acquires the system [S-400] will complicate the ability of interoperability” with US forces.

It seems as the plan for the Indian government is to fully integrate the S-400 system with the Indian Air Force’s air defense network called IACCS (integrated air command and control system), which could provide an umbrella of air defense support and serve as a deterrent against Pakistan. To complicate matters, China has also acquired S-400 batteries and Saudi Arabia has also been reported to consider a purchase. Meanwhile, Washington’s influence even among US allies in the East is waning fast.

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Authored by Jeremiah Johnson (nom de plume of a retired Green Beret of the United States Army Special Forces) via SHTFplan.com,

For several months, now, there has been a steadily growing focus on the U.S.’s implementation of increased border patrols, the creation of a permanent fence or divider on the border, and the question of illegal aliens. The president has taken a firm and unyielding stance. On June 25, AP was quoted as reporting “President Donald Trump on Sunday compared people entering the U.S. from Mexico to invaders and said they should be back without appearing before a judge.”

The president was quoted as saying, “We cannot allow all of these people to invade our country. Our immigration policy, laughed at all over the world, is very unfair to all of those people who have gone through the system legally and are waiting [in] line for years! Immigration must be based on merit – we need people who will help to Make America Great Again!”

Absolutely right: they are illegal aliens, and as they are crossing the border illegally without citizenship, they are foreign, non-citizens – aliens, by definition.

The stance of the ACLU, the Democratic Party, and other communist organizations are just such: communist platforms that are evident within Alinsky’s “Rules for Radicals,” Van Jones’ “Top Down, Bottom Up,” principle, and the pseudo-heartfelt “welcome” to the illegals from lifelong party operatives such as Nancy Pelosi and Chuck Shumer. In the manner of the “open dams” in Europe, allowing the floodgates to open up with Muslims and destroy the European nations from within, the Democrats, communist-sympathizing domestic corporations (globalist and communist are interchangeable), and the “entitlement nation” of citizen-sheeple are pushing hard to make that happen here.

From a technical standpoint, not only are they illegal aliens, but also they are invaders, just as the president stated, and that by their own admission. In the words of the Mexicans who are proponents of “La Reconquista,” the entire southwest and half of California “belongs” to the Mexicans. The exact percentage is unknown: polls of this nature are not taken, and if they were, the results would be discounted or labeled as “racist” in the manner of “The Bell Curve,” released in the mid 1990’s with amazing statistical analyses.

The majority of these “Reconquistadores” truly believe that with a combination of illegal incursions, the drug cartels, and eventually the support of the Mexican government, that the territory ceded to the U.S. in and surrounding the war with Mexico will be reclaimed and renamed Aztlan. Tens of millions have already crossed, and the majority of these illegal aliens brought that philosophy with them: thus, they are illegal aliens, and this is an invasion.

Complicit with that invasion are the politicians in the United States and the moneyed interests, lobbyists, and corporations who set up and pay the politicians’ “second retirement fund,” as in the “Clinton Foundation,” the most massive presidential money-laundering operation carried out by a former president, his family, and his network. The corporations have paid these politicians to look the other way and make it easier for illegal aliens to work in this country under the table. President Reagan had a big hand in triggering this “amnesty” mind-set with his policies that did not enforce border security or crackdowns on corporations employing illegal aliens outside of the tax-format of society.

President Trump is doing the right thing. He is setting the wheels in motion for a no-tolerance policy for illegal entry into the United States. He is fulfilling his job as the Commander-in-Chief by dealing with the border and protecting the interests of U.S. citizens as provided within the Constitution.

Time Magazine’s June 25 edition has an article entitled “A parent’s nightmare at the U.S. border.” The article is a perfect characterization of the Left’s demonization of any…any…upholding of U.S. laws relating to border control. The article uses “A young Honduran woman named Miriam” and her “18 month-old son” that she carried in her arms and walked across the border with, on grounds of “asking for asylum.”

The author’s name is Haley Sweetland Edwards (go figure), and it painted a picture of the struggling, valiant young mother and her infant son against the evils of the U.S. government who wouldn’t just let her walk across. Asylum? Viktor Belenko was granted asylum back in ’74 when he flew a MiG, the “Foxbat” to Japan and defected from the USSR. That’s a case for asylum. Haley Sweetland Edwards, you just walk across the Mexican border asking for “asylum,” and see what they do to you there, or in any other country for that matter.

The mindset is this: you give your money, open your homes, and you let them into the borders…but just don’t give them my things: that is the liberal mindset in a nutshell. Liberals are always generous with things that don’t belong to them, generous with anything that doesn’t come directly out of their pockets or bank accounts.

The irony: it does, because indirectly these illegal aliens are responsible for making their taxes rise, making their wait time in an emergency room double, and is adding to the cost of goods and services in the U.S. across the board. The illegals take jobs out of the hands of American citizens and devalue your own money, liberals, by allowing an outflow of cash that increases the balance of payments for the U.S. and undermines the economy. The president is looking out for the interests of the United States and her citizens, bottom line.  July 2 of Time Magazine’s cover has a picture of the president looking down at a crying Latino child, with the caption, “Welcome to America.”

Let’s take an investigative look at this and find out who the staff at Time is and how many of them have an interest either politically or economically or both – of allowing illegal aliens to cross the border with no restrictions. The American media is one of the vilest, most evil, most despicable institutions that has ever existed on the planet. The crimes that have been committed with their blessings make them nothing less than complicit in their commissions.

And regarding that Time issue? They don’t have a page that lists the editor-in-chief, the editorial staff, and the photographers: the anonymity to protect operatives of the communist party, card-carrying or otherwise. “Pravda” or “Izvestya” is a better title for those fawning communist-syndicated AP parrots.

Omitted are the details of the gang-bangers and narcotrafficantes, and the challenges the Border Patrol faced within the administration that was supposed to support it. Omitted are the crimes committed…murders of U.S. citizens…after these illegal aliens have been let out of detention. Fast and Furious and a dead border patrol agent was under Obama’s watch, and these detention camps that are just now coming to the forefront of the media’s camera lenses? They all sprung up during Obama’s tenure, not under the current administration.

In Europe, Hungary, Czechoslovakia, Poland, and now Italy are taking a stand and stemming the inflow of illegal aliens into their countries. The United States has the chance to do the same. The globalists cannot win unless they completely collapse nations from within and destroy and devalue the borders, language, religion, economy, and culture. They’re using mass migrations (illegal aliens) to accomplish this. In order for the president to succeed, he needs the support of the Congress and American people to stem the tide of illegal aliens into the United States.

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Authored by Tom Luongo,

Populism is popular.  Andrés Manuel López Obrador won yesterday’s election in Mexico with enough of the vote to have a clear legislative majority in the lower house.

Most of the commentary on this is fatuous.  The right wants to harp on Obrador’s past statements about the corruption in Mexico is so bad that Mexicans should seek a better life in the U.S.

The U.S. establishment derides his and his proposals as unrealistic and unworkable, which they may well be as the corruption in Mexico runs deep.  But, that said, the main reason they don’t like Obrador is because he is an outsider to the political establishment and the ruling caste of Mexico.

Martin Armstrong’s conclusions may well be right that Obrador can’t fight the tide in the short run.

He will raise taxes dramatically and we will see Mexico spiral downward into 2020. He is ill-prepared to get rid the government of corruption when the bureacracy is the problem. In fact, many who were deeply involved in the corruption saw the shifting trends and were a part of Obrador’s campaign. It is also not likely that he will make a dent in the unyielding violence of the drug war. The people are fed up with the drug wars which has escalated out of control. There were more homicides last year in Mexico than any time in the last two decades.

But the Drug War is the big issue here.  And I don’t think in any way that it is in Obrador’s power to change it.  That power lies with the U.S. president, Donald Trump.

And if you look carefully at Trump he has been attacking the Drug War and the entrenched power in the U.S. which supports it, albeit outside of the main headlines.

His focus on immigration and the opioid crisis is real.  It is aimed at staunching the flow of immigrants into the U.S. which was a fully-blessed policy of the Obama administration to turn the important red states — Texas, Florida, Arizona — blue.

He’s allowing Attorney General Jeff Sessions to attack the Drug War through the human trafficking angle which is the right way to keep the center of the country on his side while the Democrats fulminate and try to turn this into a humanitarian crisis.

And it’s simply not working.  At all.

The polling numbers are stark.  Trump’s approval rating is soaring.  His numbers among blacks and hispanics are at levels a Republican hasn’t seen in decades. The #walkaway movement is going viral.

By allowing the Left to immolate themselves by trying to turn every issue he tackles into a negative Trump is setting the stage for a post-mid-term ratcheting up of his domestic policy agenda.

And, I think, he’ll get a very sympathetic ear from Obrador on marijuana legalization.  Trump has already begun the about-face about legalizing cannabis.  Back in April he unilaterally abandoned the federal policy on a crackdown on recreational cannabis use, removing the inter-governmental stress between federal and state law.

President Trump personally directed the abrupt retreat, which came at the behest of Republican Sen. Cory Gardner of Colorado. White House officials confirmed the policy shift Friday. Trump did not inform Atty. Gen. Jeff Sessions in advance of the change in policy, an almost unheard of undermining of a Cabinet official.

Gardner was incensed in January when the Justice Department announced that it was rescinding an Obama-era policy that directed federal prosecutors not to target marijuana businesses that operate legally under state law. The senator had blocked Justice Department nominees in retaliation.

And he told Jeff Sessions to stuff his outdated and insane ideas about pot and shove them.  But, now is not the time to spend one erg of political capital on cannabis legalization.   Not when there are so many other things that are pressing geopolitically.

But, looking ahead past the mid-terms and giving Obrador some time to get settled into the office, Trump will be able to revisit this issue and clean up a number of dangling issues.

He can’t fire Sessions until after he gets a real majority in the Senate, not the fake one he has today.  If that occurs, and the odds are very good (c.f. the Democrats’ implosion above), then he’ll be able to get someone on his side through the confirmation process.

And you can bet a lot that cannabis legalization will be something the Democrats try to pin any AG candidate on.

And, back to Obrador, there is not one thing holding back a successful shift in Mexico’s future than a coordinated attack on the drug cartels’ power.

And what better way to start than legalizing cannabis?

So, today marks the possibility of a new era in relations between the U.S. and Mexico.  One where two outsiders can coordinate policy to attack the core issues creating tension.  My wife visited Mexico last year as part of a scouting trip in case we decide to ex-patriate.

And it’s very clear Trump is not popular with most Mexicans, and with good reason.  But, at the same time if he embraces Obrador’s reform plan and supports him then that attitude could change very quickly.

In the short-term, however, markets will react badly to all of this.  The Peso will continue falling as global trade collapses thanks to Trump’s war on the European Union.  No emerging market will be spared.  But, that also means there will be quite the opportunity opening up in 2019-2020 if Obrador is truly as advertised and Trump has created the power base he needs.

*  *  *

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Whether or not the PBOC finally decided to show the US it means business with the “weaponized” Yuan, but moments after today’s PBOC yuan fixing, which dropped against the dollar by a whopping 340 pips to 6.6497 from 6.6157, which while slightly lower than expected, still sent the offshore yuan tumbling, with the selloff accelerating as the currency took out one large figure after another, eventually crossing what until now had been seen as a key support level at 6.70, then quickly shooting lower and dropping as low as 6.73.

As shown in the chart above, the offshore Yuan has suffered a 10 handle drop in the span of 24 hours, an unheard of move either during the Chinese devaluation phase in the summer of 2015, or the subsequent capital outflow panic in early 2016.

As we noted this morning, yesterday PMI showed that growth momentum in the country is softening, while new export orders slumped into contraction as China’s growth dynamo suddenly goes into reverse. 

And while there are still those naive “experts” who claim that the Yuan move is not in response to Trump’s trade war, or even more laughably that 2018 is in no way like 2015 (for JPM’s explanation why 2018 could be far worse than 2015, read this), the next chart makes it quite clear what Beijing is doing to “punish” the Trump administration.

Some have suggested that China began in early April to allow the Yuan to weaken against the USD (but not against the rest of their trading partners), but in the last few days they have lost control.

The sharp drop is in line with our observations earlier today, which noted that one way or another, both the USDCNH, and Yuan vol, are set to spike in the near term. Now it turns out the near term was even nearer than we thought. This is what we said:

will China, whose currency just had its worst month in history, seek to devalue even more aggressively? Until now China has appeared to take a view that the last thing it needs is to interject CNY weakness into the equation and complicate negotiations with the US. However, the recent price action itself suggests this resolve to keep USD/CNY stable is weakening.

Worse, with the Yuan plunging, Yuan vol is surging, which in turn creates a feedback loop resulting in even more selling, leading to even more vol and so on:

The market is taking a view that China will make sure that USD/CNY is not going to intercede in ongoing negotiations with the US that will straddle the Congressional mid-term elections. However, for a currency pair that has moved from 6.38 to 6.65 since mid-June, vol still looks extraordinary low.

Well, we can now make it 6.73, as the collapse in the Yuan is accelerating.

And now we sit back patiently until Peter Navarro spots what is going on in the FX market, and how China’s stealth devaluation is no longer stealthy and tells Trump all about it, leading to the next serious of escalating trade war outbursts.

Meanwhile, expect more fireworks: the week’s key date is Friday, July 6 when 25% tariffs totaling $34 billion go into effect against Chinese exports. We already know one way that Beijing will retaliate.

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China’s newly announced ZKZM-500 laser assault rifle is able to “burn through clothes in a split second… If the fabric is flammable, the whole person will be set on fire. The pain will be beyond endurance,” according to a Chinese weapons expert cited in a bombshell South China Morning Post report.

News of this latest handheld directed energy weapon, described as a “laser AK-47” is now going viral as its claimed capabilities are jaw-dropping, foremost being that it can ignite materials from a half-mile away, and that it can cause the “instant carbonisation” of human skin and tissues.

But some in the US military and veteran community are already calling bullshit as the report appears but the latest in the tit-for-tat propaganda war with the Pentagon over advanced military tech. 

Here are further ZKZM-500’s capabilities, according to the South China Morning Post (SCMP) exclusive:

• The portable laser weapon’s energy beam cannot be seen by the naked eye, and the device makes no sound, and if concentrated for multiple bursts can set fire to a target from nearly a kilometer away.
• It’s ready for mass production based on the prototype built by Xian-based ZKZM Laser, and though officially billed as “non-lethal” (merely indicating its lethal applications are less immediate than regular firearms) will be strictly controlled by the Chinese government, with use by anti-terror squads in the Chinese Armed Police.
• Powered by a rechargeable lithium battery pack akin to those found in smartphones and can fire more than 1,000 bursts with each lasting about two seconds.
• The laser has been tuned to an invisible frequency, thus “nobody will know where the attack came from. It will look like an accident,” a researcher cited in the report said. 
• The report notes that “The lasers cannot kill a target with a single shot, but if fired at a person for long enough the weapons would start to burn a hole in their body, cutting through them like a surgical knife.”
• It is now ready for mass production and the first units are likely to be given to anti-terrorism squads in the Chinese Armed Police, who would have the capability to “carbonize” a living person.
• The laser can be easily mounted on cars, boats and planes, or can be a handheld tactical weapon, as it weights only three kilos (6.6lb), about the same as an AK-47.
• It marks a huge advance over the most recent laser “machine gun” announced by Chengdu Hengan Police Equipment Manufacturing company only last month, which can purportedly fire up to 500 meters, compared to the new weapon’s 800 meters and greater power.

What could go wrong? The SCMP report assures that “Given their potential for misuse, the design and production of the devices will be tightly monitored and the only customers will be China’s military and police.”

There are currently no international or UN-enforced bans on such advanced technology, only the UN Protocol on Blinding Laser Weapons, signed in 1980, which focuses on older technology that could cause loss of eyesight if used against aircraft or ships. 

The report further envisions the ZKZM-500’s use in both covert operations and police hostage situations: “it could be used to fire through windows at targets and temporarily disable the kidnappers while other units move in to rescue their captives,” and further: “It could also be used in covert military operations. The beam is powerful enough to burn through a gas tank and ignite the fuel storage facility in a military airport.”

However, the military website Task & Purpose says the dubious SCMP report is “probably bullshit” while identifying a number of the claims as highly suspect based on what’s currently known about laser technology. 

Task & Purpose lists the following problematic examples: 

• Range and weight are described, but the actual power system is not. Sure, anyone can claim OPSEC here, but it is hard to believe that the Chinese engineered a powerful-enough directed energy beam that can torch enemies from a half-mile away without being refracted by environmental factors like dust or fog — all with “a rechargeable lithium battery pack similar to those found in smartphones.”
• The author of the story refers to this boxy piece of shit as a “15mm caliber weapon.” I didn’t realize laser weapons had caliber? Oh wait, they don’t.
• The South China Morning Post isn’t state-run media (it’s owned by the Alibaba Group), but the story does come amid reported progress in the Chinese military’s electromagnetic railgun program. This one-two punch of groundbreaking directed energy weapon news — an area where the United States has lagged in recent years — suggest the ZKZM-500 update could just be another piece of science fiction propaganda designed to rankle the Pentagon.
• Last point: Heat-based weapons are usually bullshit. Consider, for example, the time T&P Pentagon correspondent Jeff Schogol stood directly in front of a non-lethal Active Denial System meant for crowd control and didn’t even break a sweat. Sure, lasers have come a long way since 2007, but this far? I doubt it.

And given all that’s claimed about the weapon, the price tag floated in the report seems quite economical given that enemies could be “carbonized” from afar without any hint of where the shot came from. The SCMP report lists “large-scale production at a cost of 100,000 yuan (US$15,000) a unit” — which again is not bad for such a sci-fi weapon that makes its possessor pretty much all-powerful in the face of conventional weapons. 

Public disclosure of the weapon first appeared via a technical document published on a government-run website, the Public Service Platform for National Civil-Military Integration, which listed possible applications as countering “illegal protests” by setting fire to banners from a long distance or that protest leaders could be targeted by setting fire to their clothing or hair which, the document says, would mean they lose “the rhythms of their speech and powers of persuasion”.

While we are also skeptical concerning some of the claims surrounding this latest Chinese laser gun, and await proof of its capabilities through an official field test video, it doesn’t actually seem so far outside the realm of possibility considering what can now be built in a garage.

In 2015 Military.com covered the story of an American teenager who built a “laser shotgun” in his garage and demonstrated it could light things on fire from meters away.  If this was accomplished three years ago by industrious American kids in garages, imagine what the Chinese military-industrial complex can do. So there is probably reason to be concerned.

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Authored by Jonathan Rochford via Narrow Road Capital,

When considering where the global credit cycle is at, it’s often easy to form a view based on a handful of recent articles, statistics and anecdotes. The most memorable of these tend to be either very positive or negative otherwise they wouldn’t be published or would be quickly forgotten. A better way to assess where the global credit cycle is at is to look for pockets of dodgy debt. If these pockets are few, credit is early in the cycle with good returns likely to lie ahead. If these pockets are numerous, that’s a clear indication that credit is late cycle.

This article is a run through of sectors where I’m seeing lax credit standards and increasing risk levels, where the proverbial frog is well on the way to being boiled alive.

Global High Yield Debt

Last month I detailed how the US high yield debt market is larger and riskier than it was before the financial crisis. The same problematic characteristics, increasing leverage ratios and a high proportion of covenant lite debt, also apply to European and Asian high yield debt. Even in Australia, where lenders typically hold the whip hand over borrowers, covenants are slipping in leveraged loans. The nascent Australian high yield bond market includes quite a few turnaround stories where starting interest coverage ratios are close to or below 1.00.

Defined Benefit Plans and Entitlement Claims

For many governments, deficits in defined benefit plans and entitlement claims exceed their explicit debt obligations. The chart below from the seminal Citi GPS report uses somewhat dated statistics, but makes it easy to see that the liabilities accrued for promises to citizens outweigh the explicit debt across almost all of Europe.

In the US, S&P 500 companies are close to $400 billion underfunded on their pension plans. This doesn’t seem enormous compared to their annual earnings of just under $1 trillion, but the deficits aren’t evenly spread with older companies such as GE, Lockheed Martin, Boeing and GM carrying disproportionate burdens.

Latest forecasts have US Medicare on track to be insolvent in 2026. At the State government level Illinois ($236 billon) and New Jersey ($232 billion) both have enormous liabilities, mostly pension and healthcare obligations. If you want to understand how pension and entitlement liabilities have grown so large, my 2017 article on the Dallas Police and Fire Pension fiasco and John Mauldin’s recent article “the Pension Train has no Seatbelts” are both worth your time.

US State and Municipal Debt

Meredith’s Whitney’s big call of 2010 that US state and local government debt would suffer a wave of defaults is generally considered a terrible prediction. However, after the 2013 default of Detroit and the 2016 default of Puerto Rico history might ultimately record her as simply being way too early. Illinois is leading the race to be the first default over $100 billion in this sector, but New Jersey and Kentucky could make a late surge. When the next crisis strikes and drags down asset prices, these states will see their pension deficits further blowout. At that point, there’s no guarantee they will continue to be able to rollover their existing debt.

The key lesson from Detroit’s bankruptcy was that bondholders rank third behind the provision of services and pensioners in the order of priority. Recovery rates of less than 30% should be expected when defaults occur. The key lesson from Puerto Rico was that just because a state or territory isn’t legally allowed to default, doesn’t mean that the Federal Government won’t intervene to allow creditors to suffer losses.

US Mortgage Debt

In the 2003-2007 housing boom, subprime residential lending was largely the domain of private lenders. Fast forward to today and the government guaranteed lenders are busy repeating many of the same mistakes. Borrowers with limited excess income and little or no savings are again getting loan applications approved. Fannie Mae and Freddie Mac remain undercapitalised with their ownership status unresolved, leaving the US government to pick up the tab again when the next wave of mortgage defaults arrives.

Developed Market Housing

It’s not just the US with excessively risky housing debt, Canada, Australia, Hong Kong and the Scandinavian countries are all showing signs of some borrowers taking on too much debt. Canada deserves a special mention as it combines skyrocketing house prices with second lien, HELOCs and subprime debt. It’s hard not to make comparisons with the US, Ireland and Spain pre-crisis when you see those factors present.

US Subprime Auto

The occasional articles claiming that US subprime auto debt is this cycle’s version of subprime residential debt are substantially overstating the potential damage that could lie ahead. Cars cost an awful lot less than houses with auto securitisation volumes today running at around 7% of subprime home loan volumes in 2005 and 2006. This isn’t an iceberg big enough to sink the Titanic but it is a warning of the presence of other icebergs.

The quality of subprime auto loans is poor and getting worse with minimal checks on the borrower’s ability to afford the loan. Whilst unemployment has been falling, default rates have been increasing, a clear indication of how bad the underwriting has been. Lengthening loan terms and higher monthly payments are some of the ways lenders have been responding to the rate increases by the Federal Reserve. Some debt investors aren’t too worried though, recent deals have sold tranches down to a “B” rating. In 2017, issuance of “BB” rated tranches were sporadic but as margins on securitisation tranches have fallen investors have pushed further down the capital structure.

US Student Loans

The chart below from the American Enterprise Institute breaks down US CPI into the various components. Textbooks and college tuition are the standout items with childcare and healthcare also notable. Soaring education costs have had to be paid by students, who ramped up their use of student loans. A handful of former students have managed to end up owing over $1 million. Total student debt owing is now $1.49 trillion up from $480 billion in 2006, more than credit card balances and auto loans.

Remember that many students never finish their degrees and others end up working in positions that don’t require degrees. This helps explain why over a quarter of student loans are in some form of default, deferment or forbearance. Most loans are owed to the US government, leaving taxpayers to foot the bill for defaults. Private lenders tend to cherry pick the better borrowers, often waiting until borrowers have graduated and found work before offering to refinance and consolidate their loans at a lower interest rate.

Emerging Market Debt

Whilst the developed market debt to GDP ratio has increased modestly in the last decade, emerging market debt levels have rapidly increased. China certainly skews these ratios with its extraordinary debt binge, but many other emerging markets have followed a similar pathway. The graph below from the IIF shows the combined ratios, but there’s a different make-up for developed and emerging markets. In developed markets the financial crisis led to soaring government debt to GDP ratios as governments ran deficits and bailed out banks and corporations. In emerging markets consumers, corporates, governments and banks have all increased their use of debt.

Debt markets are starting to wake-up to the risks with Argentina, Turkey, Mozambique and Bahrain all attracting the wrong sort of attention this year. This is a change from last year when I wrote about Argentina and Iraq selling bondseven though their prospects of repaying their debts appeared low. There’s been a long period of loose lending in much of the Middle East, South America and Africa similar to the conditions before the Asian financial crisis and the Latin American debt crisis.

Developed Market Sovereigns

The European debt crisis kicked off in 2009 with frequent flare ups since then. Greece’s default and restructure in 2012 saw private sector lenders take a haircut and contributed to Cyprus’s bailout later that year. The rolling series of ECB and IMF negotiations with Greece show that it’s structural problems are far from resolved and another default is likely in the long term.

Italy recently saw its cost of borrowing spike after the political parties that formed the new government considered asking the ECB for €250 billion of debt forgiveness. Both Greece and Italy have very high government debt to GDP ratios, consistently low or negative GDP growth and precarious banking sectors. Other developed nations most at risk are Japan and Portugal, ranked first and fifth respectively on their government debt to GDP ratios.

European Banks

The link between banks and sovereigns is critical to their solvency. Failing banks are often bailed out by governments, further increasing government debt levels. Failing governments often bring down their banks, as banks typically use government debt for liquidity purposes often treating it as a risk free asset. Europe has both problematic governments (Greece, Italy and Portugal) and problematic banks, mostly in Greece, Italy, Spain and Portugal. Deutsche Bank stands out for its size, high leverage and losses in each of the last three years. Given Deutsche Bank’s market capitalisation is little more than 1% of its asset base and it has shown an inability to generate a decent profit, a bail-in of senior debt and subordinated capital is arguably the only way to rectify its perilous situation.

Chinese Corporate Debt

The rapid growth of debt in China since 2009 is dominated by the corporate sector. The chart below from Ian Mombru shows that China has the highest corporate debt to GDP ratio of any country. Close to half of the debt is owed by property companies and property linked industries. This is a major risk as Chinese property is overpriced relative to incomes and there’s widespread overbuilding, especially in the ghost cities. As with almost all debt in China, there’s several issues that make risk assessment far murkier than it should be.

First, many Chinese corporates have a material level of government involvement; by direct shareholding (state owned entities), shareholdings by high ranking communist party officials, direct and indirect government guarantees of debt, communist party representatives on committees or by having local or the national government as a major supplier or customer. The distinction between corporate debt and government debt, and whether government will support a corporate that gets into financial trouble is near impossible for outsiders to accurately assess.

Second, Chinese corporates often engage in guaranteeing or lending to other corporates. Guarantees range from non-binding letters of comfort to enforceable guarantees with the existence of these guarantees often undisclosed. The potential for one corporate default to trigger a wave of others is a known unknown.

Third, corporates have engaged in substantial margin lending of their own stock. One-third of A share companies have pledged more than 20% of their stock for loans, a substantial risk in itself. Yet this is made far worse when some of the companies pledging shares have little or no profit or are trading on P/E ratios above 100. The potential for a stock market crash to trigger widespread margin calls is a known known.

Chinese Banks and Shadow Banks

It’s often forgotten that China is still an emerging market in many characteristics, with the quality of credit assessment one of those. Credit assessment in China is often based on connections and the prospective return, rather than a thorough assessment of cash flows and collateral. Whilst the default rate has ticked up this year, it remains unusually low by international standards as weak borrowers are allowed to rollover their debts. Chinese banks continue to lend to marginal state owned entities and the shadow banking sector continues to support speculative private sector borrowers.

The bank and shadow bank sectors are linked in two key ways. First, banks often package, sell and guarantee shadow bank products, typically selling them to retail buyers as a higher return alternative to bank deposits. Second, banks provide leverage to shadow bank products in order to increase the product’s headline return. When China faces its first material test of lending standards since the 1990’s, the transmission mechanisms between banks and shadow banks will allow defaults to quickly spread. The prevalence of short term lending will also serve as an accelerant.

The Main Driver of Dodgy Debt

It’s frequently noted that recessions in the US typically occur after a series of Federal Reserve rate increases. The standard response is to assume that if rate increases were delayed or occurred at a slower pace then recessions could be avoided. This misguided thinking confuses cause and effect, ignoring the three ways that low interest rates encourage the build-up of dodgy debt;

(i) cheap debt allows a dollar of repayments to support a higher loan amount, allowing projects that wouldn’t normally proceed to receive the go ahead, inflating economic growth;

(ii) cheap debt causes a short term, temporary increase in investment returns (valuations increase in long dated bonds, equities, property and infrastructure) leading some to underestimate investment risks;

(iii) the above two factors combine to drag down prospective long term returns, leading to yield chasing as investors shift from safer assets to riskier assets to meet return targets.

This process is evidenced by last cycle’s credit and property bubbles in the US. After the 2002/3 recession began, the Federal Reserve reduced overnight rates to 1%, kick starting the cycle of yield chasing and malinvestment. By the time interest rates returned to neutral levels in 2006, speculative activity was widespread. Despite the obvious impacts of low interest rates in this and many previous cycles, central banks chose to set interest rates even lower and embark on quantitative easing in 2008. The alternative of a period of cleansing of excessive debt was deemed unpalatable. The inflated economic growth levels before the crisis were a benchmark that had to be exceeded. It’s no surprise the US, Europe and Japan have all experienced unusually slow recoveries from the last crisis as the necessary debt cleansing process has been avoided or protracted.

Conclusion

In reviewing global debt, twelve sectors standout for their lax credit standards and increasing risk levels. There’s excessive risk taking in developed and emerging debt, as well as in government, corporate, consumer and financial sector debt. This points to global credit being late cycle. Central banks have failed to learn the lessons from the last crisis. By seeking to avoid or lessen the necessary cleansing of malinvestment and excessive debt, this cycle’s economic recovery has been unusually slow. Ultra-low interest rates and quantitative easing have increased the risk of another financial crisis, the opposite of the financial stability target many central bankers have.

For global debt investors, the current conditions offer limited potential for gains beyond carry. With credit spreads in many sectors at close to their lowest in the last decade, there is greater potential for spreads to widen dramatically than there is for spreads to tighten substantially. Keeping credit duration low, staying senior in the capital structure and shifting up the rating spectrum will cost some carry. However, the cost of de-risking now is as low as it has been for a long time. If the risks in the dirty dozen sectors materialise in the medium term, the losses avoided by de-risking will be a multiple of the carry foregone.

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Peter Strzok’s attorney says the beleaguered FBI agent may decline a House Judiciary Committee invitation to testify on July 10, despite previously expressing interest in doing so – over what his attorney Aitan Goelman said would be a trap.

Strzok testified last Wednesday in a closed door session a week after declaring he would do so “without immunity” and without invoking his Fifth Amendment right not to incriminate himself. None of that mattered, however, as those present say “It was a waste after Strzok kept hiding behind a “classified information” excuse, while DOJ attorneys prevented Strzok from answering anything remotely entering productive territory. 

Now, Goelman says the committee has “sharpened their knives behind closed doors” and will spring a trap on Strzok by seizing “on any tiny inconsistencies” with last week’s testimony “to ‘prove’ that he perjured himself or made false statements,” Goelman wrote in a letter to the panel somehow obtained by CNN.

“Having sharpened their knives behind closed doors, the Committee would now like to drag back Special Agent Strzok and have him testify in public — a request that we originally made and the Committee denied,” Goelman wrote.

Sounding suspiciously like Rudy Giuliani, he continued: “What’s being asked of Special Agent Strzok is to participate in what anyone can recognize as a trap.”

In his email, Goelman wrote that it was “generous to characterize many of these inquiries as ‘questions’” — suggesting instead that the GOP’s closed-door queries had been “political theater and attempts to embarrass the witness” through various leaks.

Among the questions Goelman complained Republicans put to Strzok were one about whether he loved Lisa Page, the recipient of his anti-Trump texts with whom he was having an affair, and another asking “what DO Trump supporters SMELL like, Agent?” — a reference to an August 2016 text Strzok sent in which he told Page he could “SMELL the Trump support” at a Walmart in southern Virginia. –WaPo

Goelman also called for a transcript of last week’s 11 hours of testimony, and while he didn’t rule out testimony in front of other committees, it is unclear whether Strzok will accept the House Judiciary Committee’s invitation to testify unless the transcript is released. 

Goelman anticipated that Strzok would be criticized for refusing to testify on July 10, writing that Strzok “is willing to testify again, and he is willing to testify publicly. Any suggestion that he is trying to avoid doing so is an outright lie.”

But Goelman suggested that he would not consider Strzok to be bound by the Judiciary Committee’s demands that he not speak to other congressional panels before their work was done — leaving an opening for other congressional panels to attempt to schedule interviews with Strzok. –WaPo

Perhaps Goelman realized how absurd it would look if Strzok kept de-facto pleading the fifth with the phrase: “On the advice of FBI counsel, I can’t answer that question.” 

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Authored by William Hartung via TomDispatch.com,

Other than shouting about building a wall on the U.S.-Mexico border, one of Donald Trump’s most frequently proclaimed promises on the 2016 campaign trail was the launching of a half-trillion-dollar plan to repair America’s crumbling infrastructure (employing large numbers of workers in the process). Eighteen months into his administration, no credible proposal for anything near that scale has been made. To the extent that the Trump administration has a plan at all for public investment, it involves pumping up Pentagon spending, not investing in roads, bridges, transportation, better Internet access, or other pressing needs of the civilian economy.

Not that President Trump hasn’t talked about investing in infrastructure. Last February, he even proposed a scheme that, he claimed, would boost the country’s infrastructure with $1.5 trillion in spending over the next decade. With a typical dose of hyperbole, he described it as “the biggest and boldest infrastructure investment in American history.”

Analysts from the Wharton School at the University of Pennsylvania — Trump’s alma mater — beg to differ. They note that the plan actually involves only $200 billion in direct federal investment, less than one-seventh of the total promised. According to Wharton’s experts, much of the extra spending, supposedly leveraged from the private sector as well as state and local governments, will never materialize. In addition, were such a plan launched, it would, they suggest, fall short of its goal by a cool trillion dollars. In the end, the spending levels Trump is proposing would have “little to no impact” on the nation’s gross domestic product. To add insult to injury, the president has exerted next to no effort to get even this anemic proposal through Congress, where it’s now dead in the water.

There is, however, one area of federal investment on which Trump and the Congress have worked overtime with remarkable unanimity to increase spending: the Pentagon, which is slated to receive more than $6 trillion over the next decade. This year alone increases will bring total spending on the Pentagon and related agencies (like the Department of Energy where work on nuclear warheads takes place) to $716 billion. That $6-trillion, 10-year figure represents more than 30 times as much direct spending as the president’s $200 billion infrastructure plan.

In reality, Pentagon spending is the Trump administration’s substitute for a true infrastructure program and it’s guaranteed to deliver public investments, but neglect just about every area of greatest civilian need from roads to water treatment facilities.

The Pentagon’s Covert Industrial Policy

One reason the Trump administration has chosen to pump money into the Pentagon is that it’s the path of least political resistance in Washington. A combination of fear, ideology, and influence peddling radically skews “debate” there in favor of military outlays above all else. Fear — whether of terrorism, Russia, China, Iran, or North Korea — provides one pillar of support for the habitual overfunding of the Pentagon and the rest of the national security state (which in these years has had a combined trillion-dollarannual budget). In addition, it’s generally accepted in Washington that being tagged “soft on defense” is the equivalent of political suicide, particularly for Democrats. Add to that the millions of dollars spent by the weapons industry on lobbying and campaign contributions, its routine practice of hiring former Pentagon and military officials, and the way it strategically places defense-related jobs in key states and districts, and it’s easy to see how the president and Congress might turn to arms spending as the basis for a covert industrial policy.

The Trump plan builds on the Pentagon’s already prominent role in the economy. By now, it’s the largest landowner in the country, the biggestinstitutional consumer of fossil fuels, the most significant source of funds for advanced government research and development, and a major investor in the manufacturing sector. As it happens, though, expanding the Pentagon’s economic role is the least efficient way to boost jobs, innovation, and economic growth.

Unfortunately, there is no organized lobby or accepted bipartisan rationale for domestic funding that can come close to matching the levers of influence that the Pentagon and the arms industry have at their command. This only increases the difficulty Congress has when it comes to investing in infrastructure, clean energy, education, or other direct paths toward increasing employment and economic growth.

Former congressman Barney Frank once labeled the penchant for using the Pentagon as the government’s main economic tool “weaponized Keynesianism” after economist John Maynard Keynes’s theory that government spending should pick up the slack in investment when private-sector spending is insufficient to support full employment. Currently, of course, the official unemployment rate is low by historical standards. However, key localities and constituencies, including the industrial Midwest, rural areas, and urban ones with significant numbers of black and Hispanic workers, have largely been left behind. In addition, millions of “discouraged workers” who want a job but have given up actively looking for one aren’t even counted in the official unemployment figures, wage growth has been stagnant for years, and the inequality gap between the 1% and the rest of America is already in Gilded Age territory.

Such economic distress was crucial to Donald Trump’s rise to power. In campaign 2016, of course, he endlessly denounced unfair trade agreements, immigrants, and corporate flight as key factors in the plight of what became a significant part of his political base: downwardly mobile and displaced industrial workers (or those who feared that this might be their future fate).

The Trump Difference

Although insufficient, increases in defense manufacturing and construction can help areas where employment in civilian manufacturing has been lagging. Even as it’s expanded, however, defense spending has come to play an ever-smaller role in the U.S. economy, falling from 8%-10% of the gross domestic product in the 1950s and 1960s to under 4% today. Still, it remains crucial to the economic base in defense-dependent locales like southern California, Connecticut, Georgia, Massachusetts, Michigan, Missouri, Ohio, Pennsylvania, Texas, Virginia, and Washington state. Such places, in turn, play an outsized political role in Washington because their congressional representatives tend to cluster on the armed services, defense appropriations, and other key committees, and because of their significance on the electoral map.

A long-awaited Trump administration “defense industrial base” study should be considered a tip-off that the president and his key officials see Pentagon spending as the way to economincally prime the pump. Note, as a start, that the study was overseen not by a defense official but by the president’s economics and trade czar, Peter Navarro, whose formal title is White House director of trade and industrial policy. A main aim of the study is to find a way to bolster smaller defense firms that subcontract to giants like Boeing, Raytheon, and Lockheed Martin.

Although Trump touted the study as a way to “rebuild” the U.S. military when he ordered it in May 2017, economic motives were clearly a crucial factor. Navarro typically cited the importance of a “healthy, growing economy and a resilient industrial base,” identifying weapons spending as a key element in achieving such goals. The CEO of the Aerospace Industries Association, one of the defense lobby’s most powerful trade groups, underscored Navarro’s point when, in July 2017, he insisted that “our industry’s contributions to U.S. national security and economic well-being can’t be taken for granted.” (He failed to explain how an industry that absorbs more than $300 billion per year in Pentagon contracts could ever be “taken for granted.”)

Trump’s defense-industrial-base policy tracks closely with proposals put forward by Daniel Goure of the military-contractor-funded Lexington Institute in a December 2016 article titled “How Trump Can Invest in Infrastructure and Make America Great Again.” Goure’s main point: that Trump should make military investments — like building naval shipyards and ammunition plants — part and parcel of his infrastructure plan. In doing so, he caught the essence of the arms industry’s case regarding the salutary effects of defense spending on the economy:

“Every major military activity, whether production of a new weapons system, sustainment of an existing one or support for the troops, is imbedded in a web of economic activities and supports an array of businesses. These include not only major defense contractors such as Lockheed Martin, Boeing, General Dynamics, and Raytheon, but a host of middle-tier and even mom-and-pop businesses. Money spent at the top ripples through the economy. Most of it is spent not on unique defense items, but on products and services that have commercial markets too.”

What Goure’s analysis neglects, however, is not just that every government investment stimulates multiple sectors of the economy, but that virtually any other kind would have a greater ripple effect on employment and economic growth than military spending does. Underwritten by the defense industry, his analysis is yet another example of how the arms lobby has distorted economic policy and debate in this country.

These days, it seems as if there’s nothing the military won’t get involved in. Take another recent set of “security” expenditures in what has already become a billion-dollar-plus business: building and maintaining detention centers for children, mainly unaccompanied minors from Central America, caught up in the Trump administration’s brutal security crackdown on the U.S.-Mexico border. One company, Southwest Key, has already receiveda $955 million government contract to work on such facilities. Among the other beneficiaries is the major defense contractor General Dynamics, normally known for making tanks, ballistic-missile-firing submarines, and the like, not ordinarily ideal qualifications for taking care of children.

Last but not least, President Trump has worked overtime to tout his promotion of U.S. arms sales as a jobs program. In a May 2018 meeting with Saudi Crown Prince Mohammed bin Salman at the White House (with reporters in attendance), he typically brandished a map that laid out just where U.S. jobs from Saudi arms sales would be located. Not coincidentally, many of them would be in states like Pennsylvania, Michigan, Ohio, and Florida that had provided him with his margin of victory in the 2016 elections. Trump had already crowed about such Saudi deals as a source of “jobs, jobs, jobs” during his May 2017 visit to Riyadh, that country’s capital. And he claimed on one occasion — against all evidence — that his deals with the Saudi regime for arms and other equipment could create “millions of jobs.”

The Trump administration’s decision to blatantly put jobs and economic benefits for U.S. corporations above human rights considerations and strategic concerns is likely to have disastrous consequences. Its continued sales of bombs and other weapons to Saudi Arabia and the United Arab Emirates, for example, allows them to go on prosecuting a brutal war in Yemen that has already killed thousands of civilians and put millions more at risk of death from famine and disease. In addition to being morally reprehensible, such an approach could turn untold numbers of Yemenis and others across the Middle East into U.S. enemies — a high price to pay for a few thousand jobs in the arms sector.

Pentagon Spending Versus a Real Infrastructure Plan

While the Trump administration’s Pentagon spending will infuse new money into the economy, it’s certainly a misguided way to spur economic growth. As University of Massachusetts economist Heidi Garrett-Peltier has demonstrated, when it comes to creating jobs, military spending lags far behind investment in civilian infrastructure, clean energy, health care, or education. Nonetheless, the administration is moving full speed ahead with its military-driven planning.

In addition, Trump’s approach will prove hopeless when it comes to addressing the fast-multiplying problems of the country’s ailing infrastructure. The $683 billion extra that the administration proposes putting into Pentagon spending over the next 10 years pales in comparison to the trillions of dollars the American Society of Civil Engineers claims are needed to modernize U.S. infrastructure. Nor will all of that Pentagon increase even be directed toward construction or manufacturing activities (not to speak of basic infrastructural needs like roads and bridges). A significant chunk of it will, for instance, be dedicated to paying the salaries of the military’s massive cadre of civilian and military personnel or health care and other benefits.

In their study, the civil engineers suggest that failing to engage in a major infrastructure program could cost the economy $4 trillion and 2.5 million jobs by 2025, something no Pentagon pump-priming could begin to offset. In other words, using the Pentagon as America’s main conduit for public investment will prove a woeful approach when it comes to the health of the larger society.

One era in which government spending did directly stimulate increased growth, infrastructural development, and the creation of well-paying jobs was the 1950s, a period for which Donald Trump is visibly nostalgic. For him, those years were evidently the last in which America was truly “great.” Many things were deeply wrong with the country in the fifties — from rampant racism, sexism, and the denial of basic human rights to McCarthyite witch hunts — but on the economic front the government did indeed play a positive role.

In those years, public investment went far beyond Pentagon spending, which President Dwight Eisenhower (of “military-industrial complex” fame) actually tried to rein in. It was civilian investments — from the G.I. Bill to increased incentives for housing construction to the building of an interstate highway system — that contributed in crucial ways to the economic boom of that era. Whatever its failures and drawbacks, including the ways in which African-Americans and other minorities were grossly under-represented when it came to sharing the benefits, the Eisenhower investment strategy did boost the overall economy in a fashion the Trump plan never will.

The notion that the Pentagon can play a primary role in boosting employment to any significant degree is largely a myth that serves the needs of the military-industrial complex, not American workers or Donald Trump’s base. Until the political gridlock in Washington that prevents large-scale new civilian investments of just about any sort is broken, however, the Pentagon will continue to seem like the only game in town. And we will all pay a price for those skewed priorities, in both blood and treasure.

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As Trump’s trade war with China escalates, and is set to go live this Friday when $34 billion in Chinese exports are hit with a 25% tariff, exhausted traders and concerned investors are wondering where the next surprise from the Trump administration will come from: after all, after backing off on ZTE (to get China’s blessing on the North Korea summit) Trump then promptly pivoted and nearly blocked all Chinese investments in the US, prompting a furious response from Beijing. Meanwhile, the White House somehow threatened to impose over $600 billion in tariffs on Chinese imports even.

Meanwhile, as part of the verbal escalations, the White House has proposed nearly $800 billion in tariffs on Chinese imports, which would cripple the global economy and unleash a global depression if fully implemented.

And now according to Bloomberg, on Monday Trump is going back to the Huawei/ZTE playbook, after on the Trump administration moved against letting another Chinese telecom giant, China Mobile, enter the U.S. telecommunications market, saying the state-owned enterprise would pose national security risks.

According to a filing distributed on Monday by the National Telecommunications and Information Administration (a branch of the Commerce Department), the Federal Communications Commission should deny China Mobile’s application, submitted in 2011. China Mobile said it wanted to offer international voice traffic between the U.S. and foreign countries, but didn’t intend to offer mobile service within the U.S., according to the NTIA filing.

Like in the case of ZTE and Huawei, the NTIA filing said that the US intelligence community and other officials found that China Mobile’s application “would pose unacceptable national security and law enforcement risks.”

China Mobile, owned by China Mobile Communications Corp., “is wholly owned by a sovereign state, the People’s Republic of China,” the agency said in the filing.

Of course, China Mobile is also something else: it was the world’s largest mobile phone operator in 2011, with more than 649 million subscribers, according to filing (and is probably that 7 years later).

In April, Trump blocked Chinese telecom gear maker ZTE Corp.’s access to U.S. suppliers in April, saying the company violated a 2017 sanctions settlement related to trading with Iran and North Korea and then lied about the violations. Last month, the U.S. reached a deal to allow ZTE to get back in business after the Chinese telecommunications company pays a record fine and agrees to management changes.

Now, following yet another targeted attack at a prominent Chinese company, it is only a matter of time before China responds in kind, and considering the size and prominence of China Mobile, one wonders how long until China takes aim at none other than the world’s largest company, Apple.

The full NTIA filing is below:

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Authored by Shannon McConaghy of Horseman Capital

Japan is at the very centre of the global financial system. It has run current account surpluses for decades, building the world’s largest net foreign investment surplus, or its accumulated national savings. Meanwhile, other nations, such as the US, have borrowed from nations like Japan to live beyond their own means, building net foreign investment deficits. We now have unprecedented levels of cross-national financing.

Much of Japan’s private sector saving is placed in Yen with financial institutions who then invest overseas. These institutions currency hedged most of their foreign assets to reduce risk weighted asset charges and currency write down risks. The cost of hedging USD assets has however risen due to a flattening USD yield curve and dislocations in FX forwards. As shown below, their effective yield on a 10 year US Treasury (UST) hedged with a 3 month USDJPY FX forward has fallen to 0.17%. As this is below the roughly 1% yield many financial institutions require to generate profits they have been selling USTs, even as unhedged 10 year UST yields rise. The effective yield will fall dramatically for here if 3 month USD Libor rises in line with the Fed’s “Dot Plot” forecast for short term rates, assuming other variables like 10 year UST yields remain constant.

As Japanese financial institutions sell US Treasuries, which are considered the safest foreign asset, they are shifting more into higher yielding and higher risk assets; foreign bonds excluding US treasuries as well as foreign equity and investment funds. This is a similar pattern to what we saw prior to the last global financial crisis. In essence, Japan’s financial institutions are forced to take on more risk in search of yield to cover rising hedge costs as the USD yield curve flattens late in the cycle.

Critically as the world’s largest net creditor they facilitate significant added liquidity for higher risk overseas borrowers late into the cycle.

I follow these flows closely. One area I think is rather interesting is US Collateralised Loan Obligations (CLOs) which Bloomberg reports “ballooned to a record last quarter thanks in large part to unusually high demand from Japanese investors”. CLOs are essentially a basket of leveraged loans provided to generally lower rated companies with very little covenant protection. Alarmingly, some US borrowers have used this debt to purchase back so much of their own stock that their balance sheets now have negative net equity. A recent Fed discussion paper shows in the following chart that CLOs were the largest mechanism for the transfer of corporate credit risk out of undercapitalised banks in the US and into the shadow banking sector. Japanese financial institutions have been the underwriter of much of that risk in their search for yield.

There are many other risky areas where Japan has become a large buyer, including; Australian Residential Mortgage Backed Securities, Emerging Market Bonds, and Aircraft Leases. Japan’s financial institutions have desperately sought the higher yields on offer not only to compensate for higher hedge costs but also their dire domestic earnings outlook as the Bank Of Japan (BOJ) suppresses domestic interest rates below the break-even rates that many of these institutions need to remain profitable. A former BOJ Board member Takahide Kiuchi warns “there is no doubt that as a side effect of monetary easing, financial institutions are taking excessive risk”. (Japanese) Banks are investing in products that yield too little relative to the risks involved. You tell banks to stop it, and then they go elsewhere to find opportunities — it’s whack-a-mole”. Importantly, Japan’s Financial Services Agency is now instructing regional banks, to not only stop adding foreign higher risk assets but also to aggressively sell existing positions as soon as they begin to turn sour.

Unfortunately, this doesn’t resolve the problem as restricting financial institutions like regional banks from buying higher yielding foreign assets removes their ability to offset their deteriorating domestic businesses. The situation will likely worsen, as even the BOJ Governor Kuroda himself acknowledges that continuously supressed interest rates will increasingly deteriorate domestic banking earnings over time as old higher yielding assets continue to roll-over onto lower rates. There is limited prospect of the BOJ meaningfully lifting interest rates to slow that deterioration. All of the BOJ’s measure of underlying inflation have deteriorated this year. In addition, as the chart below shows, currency effects, which had brought some limited inflationary pressures to Japan earlier in the year, are now set to bring deflationary pressures.

An unstated objective of the BOJs monetary policy has been to weaken the Yen. As suppressed domestic interest rates also creating carry trade outflows from some Japanese investors who are willing to take unhedged currency risk. The 2016 commitment to keep interest rates pegged below zero out to 10 years, via yield curve control, has again pushed the Yen to near extreme levels of devaluation against its long-term average real effective exchange rate. The Yen is currently 23% undervalued against its export partners.

We can use purchasing power parity to specifically measure the undervaluation of the Yen versus the USD. The current 30% undervaluation implies a fair value of USDJPY 77. Surveys of Japanese exporters estimate  that they only break-even on average at above USDJPY 100.5. It is clear that the BOJ would be desperate not to trigger a reversal of carry flows and push the Yen back up to fair value by raising interest rates.

The BOJ has to make a choice and there are no good options.

If the BOJ raises interest rates they risk triggering a tsunami of Japanese money flowing back home, strengthening the Yen and amplifying the coming deflationary pressures. In addition, much of that money is currently propping up higher risk overseas debt markets like US CLOs. If Japan, the world’s largest creditor, brings its money back home that would bode extremely poorly for the global credit cycle, which Japanese financial institutions are now more than ever directly exposed to.

If the BOJ doesn’t raise interest rates, which I think is the likely outcome, then some Japanese financial institutions  will simply not be able to survive as privately owned listed entities in their current form as their domestic earnings will fall increasingly negative and they are restricted from seeking overseas earnings.

Regional banks are the entities which are suffering most and conditions have continued to deteriorate further since I wrote earlier in the year of policies in place already that would allow these entities to be resolved into more viable formats. Essentially, the cost of continuing current policy would be to zero the shareholders in some of these banks, a cost Japan has proved willing to bear on a number of occasions in recent decades already. I can see this as being the most politically palatable choice, out of a range of bad choices and see continued appealing returns in Japanese regional bank shorts.

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