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DAX: Stock markets overreacting to Chinese moves?

The European stock markets have bounced modestly off their lows but remain significantly in the red at the time of this writing. Once again, the investor sentiment has been hit hard by events happening in China. The People's Bank of China set the currency fix 1.6% lower overnight, after lowering it by a good 1.9% the day before. Not many people had expected the PBoC to devalue its currency by this magnitude, certainly not for a second straight day. The latest currency devaluation has come on the day when we also had some weaker than expected macroeconomic pointers from the world’s second largest economy, most notably the latest industrial production number which showed a year-over-year increase of ‘just’ 6 per cent in July when an increase of 6.7% was expected.  The market has reacted to the Chinese data and PBoC’s moves to devalue its currency as a sign that the world’s second largest economy is struggling. Investors are also unnerved that the shock currency devaluation risks igniting the so-called currency wars, and are disappointed further that China did not opt instead for a sharp rate cut.

But is the market overreacting to the news? Essentially, a weaker yuan should help to support exports and hopefully revive growth. What’s more, the world’s other major central banks are still pretty much dovish, including the European Central Bank. As a result of the increased risk aversion, the yield on the two-year German bond has fallen to a fresh record low today. This makes the European stock markets appear more appealing following their latest pullback.

Indeed, after the sharp two-day sell-off, the DAX is now testing a major support area between 10960 and 11025 (area circled on the chart). The lower end of this range corresponds with the 200-day moving average while the upper end was the prior low and where a medium-term bullish trend line comes into play. Following such a sharp move lower over the past two days, we could at least witness a short-lived bounce here as the sellers take profit. But given the technical importance of this area, the index could potentially stage a significant rally from here. On the other hand and needless to say, a closing break below the 200-day average could pave the way for further follow-up technical selling. Whichever direction the index goes from here, the resulting break could be significant. Thus, there could well be some favourable risk-to-reward trade opportunities coming up.

If the index holds firm here then it may rally back towards the 50-day moving average at 11285 initially ahead of 11430 next; the latter was previously support and so could turn into resistance upon retest. But for as long as the index remains beneath the short-term bearish trend line and the previous high at 11670, the bulls will have to be nimble. IF and when the DAX creates a new “higher high” then a more profound rally could get underway.

Meanwhile if the DAX breaks below the 200-day moving average support on a closing basis then the Fibonacci extension levels of the most recent upswing (from point A to B) at 10850 (127.2%) and 10630 (161.8%) could be the next logical targets. Incidentally, the 10850 level also corresponds with the longer term 38.2% Fibonacci retracement of the upswing from the October low, while 10630 is only just slightly below the July low of 10650. Thus, we wouldn’t be surprised if the DAX were to find good support from these levels in the event of a break below the 200-day average.

Figure 1:

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