Trading psychology

Expectation and Sentiment

Fundamental and technical factors are undeniably essential in determining foreign exchange dynamics. There are, however, two additional factors that are paramount to understanding short-term movements in the market. These are expectations and sentiment. They may sound similar, but remain distinct.

Expectations are formed ahead of the release of economic statistics and financial data. Solely paying attention to the figures released does not suffice in grasping the future course of a currency.

If, for example, US GDP came out at 7.0% from 5% in the previous quarter, then the dollar may not necessarily move as you would expect it to. If market forecasts had expected an 8% growth, then the 7.0% reading might come as a disappointment, thus causing a very different market reaction from the one you were expecting had you not been aware of the forecast.

Nonetheless, expectations could be superseded by market sentiment. This is the prevailing market attitude vis-à-vis an exchange rate; which could be a result of the overall economic assessment towards the country in question, general market emphasis, or other exogenous factors. Using the above example on US GDP; even if the resulting figure of 7.0% undershot forecasts by a full percentage point, markets may show no reaction. A possible reason is that sentiment could be dollar positive regardless of the actual and forecasted figures. This might be due to solid US asset markets, or poor fundamentals in the counter currency (euro, yen or sterling).

A term that is commonly interchanged with “sentiment” is “psychology”. During the first two months of 2000, the euro underwent fierce selling pressure against the dollar despite persistently improving fundamentals in the Eurozone. That is because market psychology had decidedly favoured US dollar assets due to continuous signs of non-inflationary growth, and sentiment that further increases in US interest rates will work in the advantage of US yield differentials, without derailing the economic expansion.