Understanding changes in market sentiment is relevant in forex trading because higher-yielding currencies or those with central banks offering higher interest rates tend to benefit during risk-on market environments while lower-yielding currencies or those with central banks giving lower interest rates enjoy stronger demand when risk is off.
Risk-on or periods of market risk appetite refer to those instances when traders are more confident about global economic performance and prospects that they are in pursuit of higher yields, which generally carry a greater amount of risk.
On the flip side, risk-off or periods of market risk aversion include those times when traders are pessimistic about global economic performance and prospects, causing them to be more cautious and in favor of lower-yielding safe-haven assets.
As of this writing, the major economies that offer higher interest rates are Australia, New Zealand, and Canada. Aside from the fact that commodity currencies are also sensitive to global economic performance, the Australian dollar, New Zealand dollar, and Canadian dollar also enjoy significantly higher interest rate differentials from other major currencies, such as the U.S. dollar or Japanese yen. With that, the comdolls tend to rally when risk is on while the Greenback and yen benefit from risk aversion.
Lower interest rates don’t guarantee safe-haven status though, as the euro is a prime example of a currency with a low interest rate that isn’t considered as a flight-to-safety option. Even though the European Central Bank already offers low interest rates, the likelihood is that further easing measures or interest rate cuts can be implemented, thereby giving the possibility of lower returns on euro holdings.
Aside from looking at equity performance or monitoring global economic trends, another way to gauge market sentiment is to look at the Commitments of Traders Report as released by the CFTC or Commodity Futures Trading Commission. This weekly report indicates how many commercial and non-commercial traders are long or short the major currency pairs.
With this strategy, traders usually focus on extreme short or extreme long positions in order to pick market tops or bottoms. When traders are extremely short on a currency, there is no one left to sell, which means that the market will eventually turn. When traders are extremely long on a currency, there is no one left to buy, which means that price could eventually fall.
To get these figures, you simply have to visit the CFTC webpage and look for the COT report then view the short format. Just look for the currency you are interested in to see the current positioning of traders. It also helps to compare to the previous week’s report to see if more short or long positions were added. Sudden shifts in positioning could also be a sign of a market reversal.