US Dollar Sentiment Signals Shift Is Near

01/27/2011 5:01 am EST

Focus: FOREX

An important divergence between US dollar price action and FX futures and option sentiment suggests that the currency may soon set an important short-term bottom against the euro and other major counterparts.

It has been especially difficult to call for a noteworthy USD reversal amidst continued declines. Yet continued signs that few traders are betting on and hedging against further greenback weakness suggests we are near a turning point.

Timing market turnarounds is always challenging, yet at the very least, current sentiment warns that aggressive bets on US dollar weakness may be poorly advised on recent shifts in trader sentiment.

FX futures positioning data shows non-commercial traders (typically large speculators have flipped net long the euro/US dollar for the first time since November), underlining the rapid shift in sentiment for the resurgent EUR/USD pair.

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It also serves to note that FX options risk reversals have not matched the same highs seen in price, and such a divergence warns that relatively few are betting on and hedging against further euro strength.

It is always very challenging to time major reversals in price, but we suspect that euro gains may soon slow or reverse amidst waning momentum and sentiment. That said, our benchmark FX options risk reversals systems are not particularly close to taking a EUR/USD position in either direction.

A considerable disappointment in UK GDP figures led to a similarly sharp decline in the GBP/USD, as well as a sharp deterioration in trader sentiment. As of last week, we had pointed out that non-commercial futures traders were once again net long the GBP amidst a noteworthy recovery from previous lows.

FX options risk reversals showed their true worth in underlining that many traders began betting on and hedging against further sterling weakness amidst the swing in price. Given such a sharp correction, we have little option but to reverse our previous bias and stay on the lookout for further short-term weakness.

By David Rodriguez, quantitative analyst,

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