Measuring The Vital Importance Of Market Sentiment In Trading And Forex Analysis

While forex trading has evolved into a highly analytical ecosystem, the market is still governed largely by the sentiment of traders. With technical analysis often having to operate alongside fundamental analysis like breaking news and market jitters, the psychological impact of FX must always be at the core of a trader’s strategy. 

Trading psychology may be a broad term, but it remains very much in play throughout both market rallies and downturns, and manifests itself in the performance of different currencies and trading pairs. 

In the present day, where severe economic headwinds are continuing to wreak havoc with the performance of many international currencies, market sentiment can play an even greater role in rallies and corrections as fearful traders look deeper for signs of FOMO (fear of missing out) or possible changes in the geopolitical landscape. 

As the Federal Reserve continues to weigh heavily on the performance of the dollar, FxPro senior market analyst Alex Kuptsikevich has noted that the chances of further interest rate hikes in the wake of the Fed’s June 13-14 meeting weigh in at around 64%. 

This, Kuptsikevich believes, has pushed USD into overbought territory, which makes its performance in the face of psychological barriers fascinating from a sentiment standpoint. 

Finding A Pivot Through Sentiment

Using the current performance of the US dollar as an example, we can see the impact of both technical analysis and fundamental analysis in anticipating future price movements. 

By exploring the Relative Strength Index (RSI) indicator on the USD Index hourly chart, we can see that the dollar is currently ranging between 50 and 60, following a technical correction that saw the currency decline from a push that reached a peak of 70. 

This would suggest a technical correction as opposed to turning bearish. Looking to the index itself, we can see that USD is generally remaining within the parameters of 104, with brief dips towards 103. For the 104 level, we can see a 23.6% Fibonacci retracement of a November-February downtrend for the dollar, but it’s the question of what happens at 105 that will see market sentiment come into play for traders. 

Writing for FX Street, Eren Sengezer highlights that the continued use of 104 as a support level could keep buyers interested, while noting the bullish cross formations that have appeared in the 20-day and 50-day Simple Moving Averages (SMAs) points to a potential upward trend. 

However, Sengezer notes that 105 will be a major hurdle to contest with. Crucially, the analyst suggests that 105.60 will be a major pivot level for USD to overcome, citing a 200-day SMA and Fibonacci 38.2% retracement. However, Sengezer also claims that 105 makes for a significant hurdle on a psychological and static level. So why does psychology often come into conflict with technical trends? 

Psychology As The Cornerstone To Sentiment

Publishing their article in Cuadernos de Economía in 2017, Júlio Lobãoa and Cristiano Pereirab examine the existence of psychological barriers at round numbers in the major stock market indices.

Logically, a round number should carry no more relevance than any other level when it comes to technical analysis in forex. However, Lobãoa and Pereirab found that these ‘psychological barriers’ can impact financial markets in different geographies and asset classes. 

These psychological barriers occur because of many behavioral biases and the subsequent difficulty in making rational decisions among traders. The authors add that the impact of this phenomenon often affects the average market practitioner in either a direct or indirect manner. 

“It is also interesting to notice that the markets that are more volatile–in our sample, the Greek market and, to a lesser extent, the Portuguese and Spanish markets – are the ones that exhibit greater indications of psychological barriers,” Lobãoa and Pereirab add.

This strongly suggests that the current forex market for key currencies like the dollar, which has been subject to much volatility throughout many months of considerable economic headwinds, is more susceptible to these psychological hurdles. 

Furthermore, traders should be aware that these psychological barriers can form the cornerstone to changes in market sentiment, and as FX markets continue to hang on every statement issued by the Federal Reserve, we’re seeing psychology impact the decisions of traders in a more comprehensive manner. 

Changing Sentiment and The Fed

Looking closer at USD, we can see how fundamental analysis can bring rapid changes in investor sentiment. 

Taking the US Federal Reserve’s vote to increase interest rates to a 16-year high on May 3rd, we saw a strong reaction in the performance of the dollar. 

Using a regression channel to explore the extent of the decline and MetaTrader 5’s new terminal within a USD/CAD trading pair, we can see that the dollar’s strong end to May has only represented a recovery from the initial shock of the announcement. 

The quarter-point increase in the Fed’s benchmark interest rate represented the 10th hike of its kind since March 2022, when interest rates were at zero and the Federal Reserve opted to step up its battle against soaring inflation in the US. 

With inflation rates reaching highs that haven’t been seen for 40 years, interest rate hikes have long been seen as inevitable by the markets. However, now consumers are beginning to see the pinch kick into action, there had been some optimism that we were approaching the end of these consistent rate rises. 

It’s because of this uncertainty that left the prospect of another .25 hike hanging in the balance, and its impact unaccounted for by investors prior to the event. 

In late May, Federal Reserve president James Bullard claimed that two more rate hikes, preferably coming "sooner rather than later" are required to ensure that these record-breaking inflation rates are stamped out successfully. 

"I think we're going to have to grind higher with the policy rate in order to put enough downward pressure on inflation," Bullard explained. "I'm thinking two more moves this year, not exactly sure where those would be. But I've often advocated sooner rather than later."

For forex traders, the opportunities that this announcement can bring are vast when considering their impact on market sentiment. 

Whether Bullard’s intentions are for another rate hike to emerge at the next meeting on June 13th or later is yet to be determined, but for traders mindful of the changes in market sentiment that this can bring, it’s possible to study the fundamental analysis charts as new announcements are due and to operate on a field of play that transcends technical performance. 

As more volatility and uncertainty are set to reign supreme, market sentiment becomes more valuable as a fundamental indicator. In understanding the value of psychology among investors, it’s possible to add greater intelligence and strategy to positions.