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Dow Jones Faces Pressure as Inflation Bets Rise with the US Dollar

Dow Jones Faces Pressure as Inflation Bets Rise with the US Dollar

Margaret Yang, CFA, Strategist

DOW JONES INDEX FUNDAMENTALOUTLOOK:

  • Trading at a 23.8 price-to-earnings (P/E) ratio, Dow Jones’ valuation seems to be stretched
  • Rising inflation expectations and Covid-19 vaccine hopes may inhibit the Fed’s ability to inject liquidity
  • The US Dollar Index has likely bottomed. A potential bullish USD reversal may weigh on equities.

Dow Jones Index Outlook:

With a historic 53% four-month gain through August, the Dow Jones Industrial Average stockindex has almost erased all of its losses since the outbreak of the Covid-19 pandemic. As coronavirus infections are largely brought under control in most parts of the US, EU and Asia Pacific’s developed economies, investors have perhaps shrugged off initial shock and look ahead towards a gradual economic recovery.

Recent macro data delivered more positive surprises than negative ones, with the latest US weekly jobless report beating market expectations. Some 963k jobless claims were filed last week, marking a second weekly decline since the end of July. Although it is still far above the pre-Covid level, this marks the lowest weekly jobless claims tally observed since 13th March 2020.

US weekly jobless claims (in millions)

US Weekly Jobless Claims

Improving job market sentiment points to a brighter inflation outlook, which may explain rising longer-dated Treasury yields over the past two weeks. The US Treasury yield curve has steepened, as the longer-dated bond yields rose faster than shorter-dated ones (chart below).

US Treasury Yield Curve - Steepening

US Treasury Yield Curves

Source: Bloomberg, DailyFX

As inflation expectations show signs of improving, market participants are probably anticipating a less dovish-biased Fed should the economic recovery stay on track. The US Dollar Index (DXY) is reflecting this outlook too, ceasing its downward trajectory and finding a strong support at 93.0. A stronger USD is generally unfriendly to the equity markets and they have exhibited negative correlations in the past.

As the Dow moved along its upward trajectory, stocks became more expensive. The price-to-earnings (P/E) ratio of the index has risen to 23.8 – the highest level seen since the 2000 tech bubble crisis. Rich valuation renders the stock market vulnerable to technical pullbacks should negative catalysts kick in.

Dow Jones Index vs. historic P/E ratio 2016 – 2020

Dow Jones Faces Pressure as Inflation Bets Rise with the US Dollar

Source: Bloomberg, Dailyfx

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--- Written by Margaret Yang, Strategist for DailyFX.com

To contact Margaret, use the Comments section below or @margaretyjy on Twitter

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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