May 13, update: On May 13, the EUR/USD fell to $1.4068, a new low for the week. EWI's Currency Specialty Service has the latest.
Since the May 4 top near $1.4950, the EUR/USD (the euro-dollar exchange rate and the most actively-traded forex pair) has lost an incredible 700 points ("pips" in forex lingo).
That's a 7-cent gain by the U.S. dollar against the euro -- in just 4 trading days.
You'll find many explanations for this dramatic reversal in the mainstream financial press. But here's one that's not often discussed: sentiment, a.k.a. market psychology.
Sentiment has a huge influence over price trends. Whenever everyone piles into the same trade, a trend reversal is almost always at hand. Let's review some of the most recent EUR/USD reversals to see just how true that is.
Sentiment Reversal Example #1: It's late 2009, and the EUR/USD is trading above $1.51. The anti-dollar sentiment is strong: the Daily Sentiment Index (a bullish-bearish poll of traders done by trade-futures.com) is 83% in favor of the euro. The media is full of dollar-negative stories:
- "IMM speculators increase short bets on US dollar." (Nov. 30, 2009, Reuters)
- "It is the possibility of a dollar collapse that worries some at the White House." (Oct. 11, 2009, Times Online)
- "The most accurate dollar forecasters predict the world’s reserve currency will continue sliding..." (Nov. 23, 2009, Bloomberg)
- "Dodo dollar?" (Oct. 16, 2009, Jerusalem Post)
Result: To the surprise of the bears, the dollar reverses upward. The EUR/USD tops out in early December 2009 and falls for 6 months into a June 2010 low of $1.1876.
Sentiment Reversal Example #2: It's June 2010, and the euro has been falling for 6 months. The Daily Sentiment Index shows only 5% of traders bullish on the euro; 95% favor the dollar. The headlines read:
- "The euro fell to a fresh four-year low against the dollar on Tuesday on signs the euro zone's debt crisis is spreading..." (June 1, 2010, Reuters)
- "The single currency is a disaster..." (June 18, 2010, Telegraph.co.uk)
- "Medvedev Says He 'Cannot Rule Out' Collapse of Euro" (June 18, 2010, BusinessWeek)
Result: Now the dollar bulls get a surprise as the euro (and EUR/USD) bottoms and starts a powerful 4-month rally.
Sentiment Reversal Example #3: It's November 2010, and the EUR/USD is trading above $1.41. The Federal Reserve is about to announce the official start of the second round of quantitative easing (QE2). Traders are 91% bullish on the euro. Headlines say:
- "Traders bet against the U.S. currency following the Federal Reserve's decision to pump an additional $600 billion into the financial system..." (November 4, 2010, BusinessWeek)
- "If the world gets truly scared and the US dollar's tumble turns into a dollar collapse, then all bets are off... (Oct 15, 2010, CBC.ca)
- "Enter the era of dollar devaluation..." (Nov 4, 2010, Reuters India)
Result: The EUR/USD tops out on November 4th, the very day QE2 is formally announced (oh, the irony). The dollar begins to gain; the EUR/USD falls to the $1.28 range by January, 2011.
You can see all three of these examples marked with red circles on this chart (which also includes two of the cited Daily Sentiment Index readings):
Which brings us to today. Since that January 2011 low of $1.28, the EUR/USD had been gaining strongly, right into the May 4 high of just under $1.50. You know well the disdainful sentiment towards the dollar: on May 4, 93% of forex traders were bullish on the euro. The violent trend reversal and the 700-pip EUR/USD drop speak for themselves.
It's important to note that sentiment extremes are not always the sign of an immediate trend reversal; sometimes, sentiment stays pinned to the max for a long time. But you'd be hard-pressed to find a trend reversal without a preceding sentiment extreme. And if you combine sentiment readings with Elliott wave analysis, you get strong additional evidence that a new trend may be about to begin.