Sentiment is measured by assigning scores to macroeconomic and geopolitical events reported in the news.
Overall, we find evidence that the EURUSD overreacts to daily changes in macro sentiment but underreacts to monthly changes.
Overreaction to macro sentiment translates into short-term price reversal
- A contrarian strategy with a one-day holding period on EURUSD generates an average return of 7.2% per year with an Information Ratio of 0.75 after transaction costs.
Long-term underreaction leads to observable sentiment driven momentum effects
- A momentum strategy with a 1-month holding period generates an average return of 3.3% per year with an Information Ratio of 1.60 after transaction costs
1. IntroductionIn a previous study, we found that inflection points between short and long-term country sentiment are good predictors of short-term price movements in major currency pairs. We captured macro sentiment for a given economy by using RavenPack's global macro news analytics. For sentiment scoring, we used RavenPack’s proprietary Event Sentiment Score (ESS) which is designed to signal the potential impact of events on any given economy or financial market (see Appendix A for details).
In this study, we explore additional applications of the RavenPack macro sentiment indicators in the foreign exchange market. Specifically, we test the hypothesis that the value of a currency pair is correlated to the relative strength of sentiment for the economies whose currencies make up the pair. By probing news, we study how the EURUSD reacts to short and long-term changes in macro sentiment between the Eurozone and the U.S over a 3 month trailing period. We focus on the EURUSD currency pair since the Eurozone and the U.S. have similar economic activity and levels of news flow. We measure the relative strength of their economies as the ratio between Eurozone and U.S. sentiment over a trailing 3 month period. To decide whether to buy or sell the EURUSD, we observe the direction of change in their relative sentiment strength.
We propose two trading strategies based on relative strength: (1) a 1-day reversal strategy and (2) a 1-month momentum strategy. The 1-day reversal strategy is based on the daily change of the relative strength indicator and buys or sells EURUSD when the daily change is negative or positive, respectively. The 1-month3 momentum strategy is based on the monthly change of relative strength and buys or sells the EURUSD on positive or negative sentiment change, respectively, holding the position for one month. We find both the 1-day reversal and 1-month momentum strategies to deliver consistent performance during the back-testing period from January 2004 through April 2013.
In the next sections, we review the construction of our macro sentiment indicators for a given economy, evaluate the 1-day reversal strategy and the 1-month momentum strategy, and deliver our conclusions.
2. Constructing Macro Sentiment Indicators
As previously described, the relative strength of macro sentiment between the Eurozone and the U.S. is measured as the ratio between the 3-month macro sentiment indicators for the two economies. The indicators are measured as the...
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