How to gauge market sentiment using Forex

Jan 15, 12:30 pm

Risk On, Risk Off.. or RoRo as its commonly called, is probably an important term widely used in the financial markets, regardless of what assets one is trading. Depending on how the underlying sentiment prevails, traders can use this information to their advantage and thus be able to position themselves accordingly.

What is market sentiment?

Trading is mostly based on sentiment or what investors feel. When investors are bullish, they tend to take on more risk. Also known as “Risk-On sentiment”, in this scenario, investors prefer to shun low yielding assets and instead buy up the riskier, volatile and high yielding markets. For example, a typical risk-on sentiment is often seen by the equity markets pushing higher while the low yielding, safer assets such as US treasuries seeing a decline.

Alternatively, when investors start to feel cautious about the markets, they tend to scale back their bullish bets and instead opt for the safe or low yielding assets such as the US treasuries while selling off their stake in the risky assets such as stock markets.

Why does the market shift between risk on and risk off?

The reasons are many. For starters, risk on is usually seen in times where the investors feel good and there are no major risks. For example, a good US jobs report is often seen with gains in the stock markets, all things being equal. Likewise, disappointing jobs or GDP data could usually signal a risk-off sentiment. However, it is not that simple. Market sentiment is shaped by many factors and is often not limited to just one geographic or economics.

A good example is the more recent market selloff that was triggered by China’s weak data earlier this year. Equity markets (often considered risky but high yield) plunged across the board while safe haven assets fared better under the circumstances.

Applying Risk-On Risk-Off to the Forex markets

With a fair idea of the market sentiment, let’s take a look at how the RoRo applies to the currency or forex markets. Firstly, among the major G8 currencies (AUD, USD, CHF, GBP, EUR, JPY, NZD, CAD), there are significant categories which determine them into a ‘Safe Haven’ and a ‘Risky Currency’ summarized in the table below.

Safe Haven Currencies         Risk Currencies
USD                                                   AUD
JPY                                                    NZD
CHF                                                  CAD

Risk-On Sentiment: AUD, NZD and CAD tend to outperform the safe haven currencies
Risk-Off Sentiment: USD, JPY, CHF tend to outperform the risky currencies
*Note: The US Dollar’s performance is mostly neutral but in strong risk-on sentiment, the Dollar tends to rise strongly.

How to determine market sentiment before starting your trading day?

1. Start with the Asian markets (if you are trading the European/US session) and/or look to how the US markets closed the previous day.
2. If you notice the markets being sold off strongly, most importantly, the Nikkei225 and the US S&P500 and the Dow Jones Index chances are that a Risk-Off sentiment is prevailing and, therefore, Yen, CHF are likely to outperform AUD, NZD and CAD. Alternatively, if the US and Asian equities closed with strong gains, the market is in a Risk-On sentiment then the AUD, NZD and CAD will outperform the safe haven currencies, Yen and the CHF.
3. Of course, one should not trade blindly on the sentiment alone but also conduct individual assessment of the currency pairs before entering a position
4. Note that sometimes, market sentiments can reverse rather quickly within the day and this highlights the importance of doing a thorough fundamental and technical analysis on the currency pairs.
5. Gold is also an important indicator of risk sentiment. Gold prices tend to rise mostly on rising geopolitical tensions and market uncertainty.
6. A special note on EURUSD. When the German DAX is down following its peers, the Euro tends to rally to the Dollar.

Market Sentiment – Chart Examples

Risk Off Sentiment
Market: Risk-Off Example

Risk-Off Sentiment
• Equities fall (Nikkei225, Dow Jones, S&P500)
• JPY outperforms AUD risk asset
• EUR outperforms AUD risk asset

Chart-2-Risk-On
Markets: Risk-On Example

Risk-On Sentiment
• Equities rising
• JPY turns weak as risk currencies gain
• NZD outperforms USD, AUD outperforms JPY

Gauging Market Sentiment – Conclusion

As illustrated, understanding market sentiment can help traders to better position themselves and also helps traders to pick the currency pairs that are most likely to offer big gains. The market sentiment is nothing but Inter-market analysis and with due practice, traders would be able to tell which way the ‘wind’ is blowing and thus be able to make money in the forex markets regardless of how the markets perform.

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