Market Sentiment, Risk Appetite and Money Flow

The financial markets are run by people.

Yes, cash influx into all markets comes predominantly from institutions, but at the heart of those decisions within the institutions is people.

And yes, in our current stage of rapid technological advancements, algorithms are becoming increasingly abundant in financial decision making, but for the most part, the final button is, more often than not, pushed by a person.

Investors won’t buy into analytics if it returns a suggestion that doesn’t fit their logic, or a solution that they can’t seem to justify. When your neck is on the line in an investment bank, you can’t say “the model told me to do it” as a reason for why your trade is in the red.

In addition to this, algorithmic models bias themselves towards investor opinion. An investor provides a model with the inputs that they believe are the most indicative of future market performance in the hope that the model will find sophisticated relationships within the data for him/her. Models only work with data that they’re given, which is provided by the investor, so everything eventually ties back to people.

So why is this important? Well if we can understand how these players in the markets think, how different groups of individuals will react to news articles or government policies, then we can start to build a picture of future outlook. We can start to aggregate these opinions into actual numbers and study the effects this has on different markets.

This introduces a few of the most fundamental concepts in what drives financial markets - risk appetite and market sentiment. These are the main drivers of demand in the markets, which directly impact the direction we see prices move in.

Market sentiment is a view on the general consensus of investors towards a particular asset. The first chapter from “A 3 Dimensional Approach to Forex Trading” by Anna Coulling describes this concept perfectly. It begins by stating that investors make decisions for two reasons - to make money, or to protect the money they have. When an investor is feeling bullish, he looks to put money into riskier assets that offer higher returns. The economic outlook is strong and the investor fancies his chances with risk. As the market sentiment looks more positive, risk appetite also tends to increase.

On the other hand, when market sentiment looks more negative or perhaps just uncertain, investors tend to dial back the risk. Money will flow out of high risk assets and into low risk assets, or safe havens. Risk appetite falls and investors look to avoid the risk of wiping out the gains they have already made.

The cyclical nature of the markets, part of which is also influenced by monetary policy measures, ensures that different assets will grow at different times of the year, depending on their risk profile and current market situation. This impact is seen in the form of money flow. Money flows between assets depending on sentiment and risk. Although there are far more complexities to the financial markets and as such these relationships aren’t perfectly correlated, we tend to see prices of what we consider low risk assets to rise when sentiment is uncertain and in the same vein, prices of higher risk assets will rise when the outlook is positive.

This is just one building block to the financial philosophy I’m trying to impart with this newsletter. Whether you intend to use this content as another tool for your trading activities, or you just want to understand more about the world economy, my aim is to provide the global view before honing in on finer details.

From a trading perspective, a lot of currency traders in the market fail because they look at charts in isolation. They might follow so called “experts” trying to sell you a get rich quick pipe dream, whilst all they actually do is draw technical analysis lines on a chart without consideration of the overall market position. My aim is not to provide blind signals, but to provide a wider understanding. I definitely do believe in the power of technical analysis, but if we can also incorporate the fundamentals, it only makes us more informed as traders, economists or simply enthusiasts.