PSYCHOLOGY OF TRADING 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 release of economic statistics and financial

data. Solely paying attention to figures release 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 have been 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Nonetheless expectations could be superseded by market sentiment.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 as 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 the

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, pound etc).

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 Euro

zone. That is because market psychology has had decidedly favored US dollar

assets due to continuous sign of non-inflationary growth, and sentiment that

further increase in US interest rates will work in the advantage of US yield

differentials without derailing the economic expansion. As the word

"sentiment" describes, market sentiment is simply what investors feel about the

market - regardless if their feelings are entirely justified or true. As such,

market sentiment could be - and is - influenced by rumors and false reports.

For example, recently a reporter from The Independent reported that the oil

states of the Middle East were in talks to stop using the US Dollar for oil

trading. Even though the report was repeatedly denied as false, it still had an

impression on the market.