What Is Market Sentiment?

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by Vicki Schmelzer

Market sentiment is an overall attitude of investors toward a specific security or the financial market at large. Market sentiment is a squishy term referring to tone and feeling. In the broadest context, it is crowd psychology, and crowds, like individuals, can possess a wide range of emotions beyond the oft-cited fear and greed.

A good way to understand market sentiment is to understand what it is not. What one trader thinks is going to happen to a specific currency pair may or may not be the same as what the trading community collectively thinks is going to happen. There are times when being a contrarian makes sense, but a trader cannot be either a crowd-follower or a contrarian if he does not know what the market as a whole is thinking.

Gut Feeling Versus Market Sentiment

You are coming home late from a party and walking down a dimly-lit street. There are no other pedestrians walking and no cars driving by. Something inside your brain starts telling you to walk faster and walk in the middle of the street or to turn around and find an alternative way home. This is your “gut instinct” speaking.

Seasoned traders have “gut” feelings all the time, especially if they have traded currencies for a long while. For them, trading is a dance. They instinctively know when to take a step back, then forward, and then to the side. These traders can tell, sometimes without looking at technicals, flow information, or FX strategists’ projections, if a currency pair is overbought or oversold. However, this is a skill that, even after many years of trading, is not always acquired. This is why understanding what the market is thinking about risk and a given currency and how market players are positioned is key to being a successful trader.

Market Sentiment About Risk and Market Sentiment About a Currency

Before entering into a currency position, the trader needs first to understand whether the market is currently willing to put on risk or is risk-averse. In times of uncertainty, perhaps ahead of a central bank decision, an election, or in the event of a natural disaster, the market may go into lock-down mode, exiting or at least paring back positions in what are deemed risk-friendly instruments. Global investors typically sell stocks and buy bonds during these circumstances, with the currencies of the bonds purchased usually benefiting.  Similarly, when there is no sign of turmoil in world financial markets and world growth seems assured, global investors are willing to embrace risk again. Stocks and commodities tend to do well then, and bonds and currencies such as the dollar and the euro, purchased as safe havens, may slip again. Traders watch various risk gauges daily, to see if these gauges are flashing warning signs, are neutral, or are “risk-on.”

Only once the global investors’ appetite for risk is understood, can a trader then move on to try to grasp the market’s view about a given currency. To gauge current sentiment about a currency, a trader will look at technical analysis, positioning (from Commodity Futures Trading Commission, Tokyo Financial Exchange, and other sources), flow information (custody bank information), and market forecasts.

As an example, if the market is risk averse, global investors may look to buy US Treasuries. Whether the funds to buy the Treasuries come out of US stocks or from abroad will help determine if the US dollar benefits from these flows. Say these flows do come from abroad. If the market is already heavily long dollars, new dollar demand may not provide much support since players will look to take profit. If the market is heavily short dollars, for whatever reason, and there is a squeeze, the dollar may rally much further than usually even on limited demand.

Country Sentiment Versus Currency Sentiment

While counter-intuitive, there are times when the market sentiment towards a given currency is positive, even while sentiment towards the currency’s country is negative. In October 2013 when there was great uncertainty about whether the US would raise its debt ceiling and resolve budget negotiations, the dollar maintained a bullish tone. During the eurozone crisis, global investors were scrambling to exit peripheral country debt. Because these investors flocked to both US Treasuries and German Bunds, the euro fell, but did not fall out of favor as much as many traders expected.

Pro tip: Think of a safe-haven instrument, whether a bond (US Treasuries, German Bunds), commodity (gold), or currency (typically the US dollar and other currencies with large bond markets), as “comfort food,” i.e., something you eat when you are feeling sick or depressed, such as Grandma’s chicken soup or a piece of chocolate. Once you are feeling better, you do not have the desire to eat chicken soup or Godiva chocolate. It is the same with currencies: market players buy a safe-haven currency because they feel they will not lose money or will lose the least amount of money holding it. Once the danger has passed, these players will exit these currencies and look again to re-enter risk waters.

Quiz:

1. Market sentiment is more important than economic facts in trading Forex.

2. It is better to be a crowd-follower than a contrarian.

3. Attitudes toward risk in all markets is more important than any country or currency bias.

Done