DAX European stocks likely to benefit from Fed hike

December could be a month of two halves: the first for the bears and the second for the bulls. Since the start of this week, the buyers seem to have taken control once again. And who would blame them? After all, the mini correction that started at the end of November means the indices are at relatively more attractive levels in a month which is usually a positive one for equities. Added to this, some would argue that there are not many reasons for equities to fall off a cliff, even if the valuations look a little bit stretched. For one, concerns about the health of the Chinese economy have receded somewhat after the publication of stronger industrial production data at the weekend. Today’s economic data in the Eurozone has likewise been positive, with the manufacturing activity in the single currency bloc rising to a 20-month high in December and also improving in both Germany and France, according to the latest PMI figures from Markit. What’s more, the sell-off in commodity markets has eased for now, providing some relief for miners and energy companies. Investors also appear sanguine about a potential rate increase in the US today (for details, please refer to my colleague Matt Weller’s FOMC preview article HERE). In fact, a US rate increase could be a positive outcome for European stocks as it is likely to further widen the short-term yield spreads between the Eurozone and US bonds, putting downward pressure on the EUR/USD exchange rate. A weaker euro would further boost the appeal of European exporters, even if the reputation of German carmakers is tarnished somewhat following VW’s recent emissions scandal.

That being said, we are not totally out of the woods just yet and the so-called Santa Clause rally may remain elusive should the Fed’s actions today – or lack thereof – trigger the “risk-off” switch. As the end of an era for record low rates approach, the junk bond market is already feeling the side effects. US equities, which have been rising for the best part of the past seven years on the back of falling interest rates and unconventional monetary policy measures by the Fed and indeed other central banks, could well be the next big domino to fall. And when the US sneezes, the rest of the world catches a cold, so they say. But the potential US rate increase today will be small and the Fed is likely to accompany it with a dovish message. Essentially, rates will still remain near historically-low levels, which is unlikely to cause major shockwaves in US equity markets in the near term, given that most other global central banks are still pretty much dovish and yields are universally low.

Although the US indices do appear fatigued at this stage of the bull market, I have a feeling that we may see one final parabolic-like upsurge at some stage before a top is formed. In Europe, the German DAX may have resumed its long-term bullish trend once again. As can be seen from the daily chart, below, the benchmark stock index had already formed a double bottom reversal pattern at the end of September around the 9300/25 area. From here, it went on to rally aggressively and eventually reached, and momentarily surpassed, the 61.8% Fibonacci retracement level at 11220 against the all-time high (of 12400/5).  The index then peaked at 11430 at the end of November and the failure there led to a sharp drop in the first half of December. Interestingly, and as is often the case for the DAX, the sell-off ended – for now, anyway – around the 61.8% Fibonacci level at 10115/20 against the double bottom low.

At the time of this writing, the index was testing the pivotal 10520/30 area again, which had been strong resistance and support in the past. While it is possible the index could turn here, some of the other global indices, including the FTSE 100 and S&P 500 have broken their corresponding levels. Thus, the DAX could follow suit. A decisive break above this key area would be a very bullish development in my view. At the very least, the bulls may then aim for the 38.2% retracement of the most recent downswing (from point B to C) at 10620 next. The 61.8% retracement level comes in at 10930 and this would be the second near-term upside target. Further resistance levels include the 200-day moving average, currently at 11055, followed by the longer-term 61.8% Fibonacci level at 11220 and then the November high at 11430. But potentially, the index could go on to achieve its double bottom measured move target at around 11720 over time, where it will also meet a couple of Fibonacci levels too.

Meanwhile if the index fails to break through some of the key resistance levels mentioned above and drop back below 10520 pivotal support on a daily closing basis, then a revisit of the long-term bullish trend around the psychologically-important 10000 mark would be possible. But as things stand, the DAX is looking strong once again and traders may want to act on any bearish developments with extra caution and after some sort of confirmation.