Sentiment measures
The value of a currency is driven by two things- the country’s fundamentals, and currency sentiment. It is fairly obvious how to measure the fundamentals (central bank rate, current account balance, budget balance, GDP growth etc), although care must be taken, as governments distort these numbers to their own purposes. Gauging sentiment might appear to be harder. Perhaps reading what Bloomberg has to say, or listening to CNBC? Frankly, more objective measures are needed.
I have found a number of sentiment measures that indicate what the major market players- banks, large traders, market-makers- are thinking. Add in a few indicators for risk sentiment, and you have a useful set of sentiment measurements.
Risk Reversals
Risk reversal refers to the manner in which similar out-of-the-money call and put options, usually FX options, are quoted by marker makers and dealers. Instead of quoting these options’ prices, dealers quote their volatility. The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge the market-makers directional sentiment- they will set implied volatility higher in the direction they think the currency will go.
Sovereign Credit Default Swap (CDS) Rate
A credit default swap is a bilateral contract between a protection buyer and a protection seller. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction. In basic terms, the lower the rate, the lower the possibility of default. They are quoted in basis points, or bps. Thus, a CDS rate of 42bps (Current UK rate) carries twice the cost of the US rate, 21 bps, reflecting a higher possibility of default on UK government bonds (Gilts).
Currency Futures
This very useful metric indicates the number of contracts – long, short and spreads- taken out on the Chicago Mercantile Exchange. Obviously, if there are more longs than shorts, the sentiment is positive for the currency. There are actually two different series- one is for banks (reported monthly), the other for all other parties (reported weekly). I like looking at both, because the banks are often the market makers and must hedge their positions.
Risk appetite is a term used to reflect the appetite of the market for the higher-yielding/higher risk currencies (AUD, NZD, GBP, INR). Its opposite is Risk aversion, and reflects appetite for lower-yielding/lower-risk currencies (JPY, USD, CHF). I have found a number of useful gauges of risk sentiment.
TED spread
TED (an acronym from T-bill and ED, the sticker for Eurodollars) spread is the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.
The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the risk of default is considered to be decreasing. An increasing TED spread is a risk aversion indicator.
Counterparty Risk Index
There are two (that I know of) indices, one compiled by Credit Derivatives Research, the other by Markit. The indices measure the current risk (mainly by surveying dealers) in the derivatives market that one party will default.
VIX or volatility index
VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market’s expectation of volatility over the next 30 day period. An increasing VIX is a risk aversion indicator.
I used to count the VIX as a good risk sentiment indicator, but the VIX has been corrupted (IMHO) by the large component of program trading in the US equity market. I sill include it in my sentiment indicators but do not give it the weight it used to have.
So there are 5 or 6 good measures of sentiment in the market. Rather than look at them instantaneously, I prefer to look at their trends (eg what has the risk reversal done over the last month), which matches my longer-term trading horizon.
Paul Stafford is an FX analyst, and writes a weekly Currency Briefing, which includes all of the above metrics and much more. Visit 4xtradertools.com
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