Other Ways to Measure Market Sentiment

by Vicki Schmelzer

The term “market sentiment” really means two things: the market’s appetite for risk in general as well as market player’s desire to own a specific instrument. In currencies, a trader may wildly want to buy Aussie on expectations that the Reserve Bank of Australia will soon hike rates, but if the market is risk averse and thus is buying US Treasuries and the dollar, Aussie may tumble instead. Just as traders look for evidence of risk appetite in specific currencies (see the lesson on the Commitments of Traders Report), traders eye risk gauges for insight into market views towards a given currency, commodity or interest rate product.

Popular Risk Gauges

The most popular risk gauge is the Chicago Board Option Exchanges volatility index or VIX, which is a key measure of market expectations of near-term volatility as reflected in S&P 500 stock index option prices.

The VIX takes a weighted average of all the S&P 500 option prices and derives a percentage that represents views about future direction. If the VIX is at 18, it means that the S&P 500 should stay within a +/-18% range for the coming year.

VIX levels over 40 are considered to reflect risk aversion and VIX levels below 20 are viewed as risk friendly. At the peak of the US financial crisis in October 2008, the VIX posted a new record high of 89.53. Two months earlier, the VIX had been traded a bit below 19.

Those watching the sharp rise in the VIX would have been alerted to the fact that market players were becoming increasingly risk-averse and seeking out safe havens.

The CBOE also has a Euro Currency Volatility Index (EVX) which is known as the “euro VIX.” This index became more popular during the eurozone crisis. The euro VIX “measures the market's expectation of 30-day volatility of the EUR/USD exchange rate by applying the VIX methodology to options on the Currency Shares Euro Trust (Ticker - FXE). Like other VIX benchmarks, EVZ uses options spanning a wide range of strike prices,” the CBOE explains.

Financial Stress Indexes

Many argue that the VIX is too equity-oriented and prefer risk gauges that look at a wider array of instruments. In response, three Federal Reserve Banks have developed their own separate "financial stress" indicators to gauge if there is trouble brewing in financial markets. Each financial stress index considers different variables, but all seek to be the first to sound warning bells about negative developing trends.

The Kansas City Fed's FSI (KCFSI)  released monthly, considers 11 variables, seven of which concern yield spreads and four of which track the behavior of asset spreads, while the St. Louis Fed’s FSI (STLFSI), released weekly, considers 18 variables.

Many banks have their own stress indexes that consider changing dynamics in a variety of instruments, but often these FSIs are proprietary. The Fed financial stress indicators are easily available online.

Market Sentiment Indicators

FX traders glean the most information about market sentiment towards a currency from positioning data, which is why the CFTC’s COT report is so closely watched. Traders also look at reports on “open interest” (number of contracts that have not settled) at the Chicago Mercantile Exchange, which tells them also which way the market is leaning towards a given currency. Some retail FX platforms offer their own positioning and flow information about their clients to their other clients, but because of fragmentation in the Forex brokerage industry, no single platform is big enough to offer a significant chunk of client positioning data.

Outside the USA, other such positioning reports include the weekly Ministry of Finance data from Japan, which reports on fixed income and equity inflows and outflows, Tokyo Financial Exchange (TFX) data, and equity flow data released by the Tokyo Stock Exchange (TSE).  What global investors are doing in stocks and bonds is often reflected in currency moves.

The market eyes weekly data released by Emerging Portfolio Fund Research or EPFR Global, a subsidiary of Informa. Their current report tracks daily, weekly, and monthly equity and fixed income fund flows, and monthly fund allocations by country sector and security. Each Thursday, EPFR releases the flows seen over the past week, with the data including flows up until the prior business day (Wednesday). Emerging Portfolio Fund Research tracks traditional and alternative funds domiciled globally with $16 trillion in total assets under management. EPFR’s full line-up includes: Equity Funds, Bond Funds, Money Market Funds, Balanced Funds, and Alternative Funds. Each category is comprehensive and has multiple sub-categories.

Bank of America Merrill Lynch has a monthly fund managers’ survey, which offers insight into portfolio manager views and current holdings on equity, fixed income assets, and currencies.

While deemed backward looking, more directional players will eye the Treasury International Capital System (TICS) report, which is released monthly by the US Treasury around the 15th of the month. The data, which refers to transactions done two months earlier, is sifted to see whether US investors are buying or selling fixed income/equity instruments overseas and whether foreign private and official accounts (especially central banks) are buying or selling US Treasury bonds and notes, government agency bonds, corporate bonds, and equities.

There are monthly reports on hedge funds (TrimTabs/BarclayHedge), and corporate flows, but these are not as readily available. Many banks now offer a breakdown of their client flows. Custody banks, such as State Street and Bank of New York Mellon, currently offer daily, weekly, and monthly updates on transactions executed for clients in stocks, bonds, and currencies. These capture only a small portion of the daily $7.5 trillion in FX turnover, but are considered accurate reports of real money transactions. Not all of the data is publicly available however, with some flow reports released solely to clients and bank personnel.

• Pro tip : These reports taken together help to shape a trader’s view about a given currency. Taken alone, they may offer only one-dimensional information.