Dollar is riding for a fall in 2017

With the US Federal Reserve raising interest rates, and President Mario Draghi of the European Central Bank seemingly unable to escape his addiction to quantitative easing policy, many investors are questioning who wants to buy the euro. The answer is simple. The whole world is eager to buy the euro. The problem in 2017 is more likely to be finding anyone who wants to buy the US dollar.

The Middle East is a good example of a region of avid euro buyers. Even with the recent rally in the oil price, most Middle Eastern countries are expected to run sizeable fiscal deficits. The IMF expects Saudi Arabia to run a fiscal deficit of almost 10 per cent of GDP next year. To fund their budget deficits, the Gulf countries are selling central bank reserves and pools of assets held by their sovereign wealth funds.

Imagine Saudi Arabia sells US Treasuries, and uses the dollars it receives to pay its civil servants. Then imagine that a Saudi Arabian civil servant takes their pay and uses the money to buy a BMW car in euros. What is happening? Saudi Arabia is selling dollars and buying euros. It does not matter that there is an asset on one side of the transaction and a BMW on the other side of the transaction — the foreign exchange market implication is the same whether it is Bunds or BMWs that are bought.

If the Middle East buys assets, they like their assets to be made in America (central banks buy roughly twice as many US assets as other assets). If the Middle East buys products and services, they like their products and services to be made in Europe (the Middle East buys twice as much from Europe as from the US). Thus if the Middle East is selling assets to buy goods, it sells dollars to buy euros.

Of course this does not just apply to the Middle East. The world is eager to buy euros because the world wants European products (in preference to US products). The relative current account balances of the Euro area and the US alone tell us that. China, another economy inclined to divest itself of US assets of late, buys more euro area imports than US imports. The same is true of the APEC Asian economies as a bloc. Africa’s preference for Euro area products in comparison to American is overwhelming. Only Latin America exhibits any relative desire to buy “made in America”. The rest of the world clamours for euros to obtain goods and services from their preferred supplier.

So why is the euro not stronger with all this enthusiastic buying of BMWs and other euro area goods?

In 2016 the US basically pleaded with the rest of the world to lend it money. US interest rates are above those of the euro area (euro area interest rates are negative). US bond yields are above those of the euro area (many euro area bond yields are negative). US equities have outperformed those of the euro area (by about 15 per cent, and euro area equity performance is negative this year). The US basically did everything that it could to persuade investors to buy dollars — and at the end of all of that effort the euro still trades within 4 per cent of where it traded against the dollar at the start of the year.

The challenge for the US is that it needs foreigners to buy dollars every day to stop the dollar from falling. In the first nine months of 2016, foreigners had to purchase $2.7bn every day. That is more than the daily GDP of the Netherlands. Any day that foreigners were not inclined to buy $2.7bn, the dollar would weaken. This is important — if foreigners decide that they want to “wait and see” what Donald Trump’s policies are like before committing to buying more dollars, then the dollar will fall. “Wait and see” is not good enough for the US.

The question is not who wants to buy euros — the whole world wants to buy euros because the whole world wants to buy euro area products. The US had to offer considerable financial incentives to persuade foreigners to buy dollars.

It seems unlikely that the incremental incentive of a couple of US interest rate increases will suffice to combat the incremental uncertainties of an unconventional new administration. The question for 2017 is — in the new abnormal of the United States, who can be persuaded to buy dollars?

Paul Donovan is global chief economist at UBS Wealth Management