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Why ASX investors should be ignoring warnings from the bearish bond market

Are we in for a multiple-day sell-off on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index?

This is the question on the minds of many investors after the 1.1% market tumble with the Eclipx Group Ltd (ASX: ECX) share price, Altium Limited (ASX: ALU) share price, New Hope Corporation Limited (ASX: NHC) share price leading the ASX 200 lower.

Bearish signals spreading across bond markets that are ringing the bell on a possible recession have been blamed for Monday’s sell-down but Macquarie Group Ltd (ASX: MQG) believes there is a better market signal to be looking out for.

The broker is telling investors not to look at bonds but to listen to “Dr Iron Ore”!

Why you shouldn’t count on bonds getting it right

It’s copper that is typically bestowed such an honorific for its ability to dictate the direction of the commodities market, but Macquarie thinks iron ore deserves such a title as well as it can set sentiment on the ASX.

It seems bond yields aren’t particularly good at predicting a downturn in our equity market, according to the broker who looked at the last four major lows in stocks.

“Before QE [quantitative easing], bond yields often troughed before, or near the low in equity prices. But Australian bond yields troughed 3 months after stocks in 2011/12 and nearly 6 months later in 2016,” said Macquarie.

“The lag might get even longer as some investors anticipate not only rate cuts but also QE in response to slowing economic growth. With a more dovish Fed since January, and rising expectations of RBA cuts, there are reasons why bond investors may want to continue to push down yields (for now). The data shows the yield curve is now a better predictor of inflation than growth.”

A better lead indicator

Here’s why iron ore steps in. Macquarie believes iron ore is a better lead indicator for the ASX than bonds and even copper.

“Iron ore prices bottomed 31 days before stocks in 2016 and 24 days before stocks at end-2018,” added the broker.

“Copper’s low was 28 days before stocks in 2016, but lagged the 2018 low by 2 weeks.”

There are a few reasons why iron ore is looking like the smartest one in the class at predicting turning points for the ASX. The move towards spot pricing for the steel-making ingredient instead of longer-term contracts is one factor, according to Macquarie.

Iron ore has also become a VIP (very important product) to China’s growth story, while the commodity is playing an even bigger role in driving growth in the Australian economy – both as our number one export and its impact on miner’s earnings and the federal budget.

“While there could be a correction following the rally since December, we think a new bull market in global stocks likely started at the end of 2018,” added Macquarie.

“Typically, you get at least a year of uptrend in a new cycle, so 2019 overall should be good for stocks.”

Fingers crossed fellow Fools!

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Motley Fool contributor Brendon Lau owns shares of Macquarie Group. The Motley Fool Australia doesn't own shares mentioned in this article. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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