Counter-cyclical? TIPs vs. IOCs

Treasury Inflation Protected Securities (TIPs) are U.S. Government bonds which adjust the coupon payments for inflation. The bonds make explicit the two typical sources of return in a bond: the "real" return and the "inflation" return. The two together combine for the total or "nominal" return.

Assuming the U.S. Government pays its debt, then the real risk of TIPs bond is in the "real" return component. If the economy's rate of growth exceeds the rate priced into the bond, then the purchaser will suffer low returns. However, if the economy is slower than anticipated by the rate priced into the bond, then the purchaser will enjoy superior returns.

Expectations are the key here. In 1999, the economy was buzzing and TIPs bonds priced in real returns that far exceeded those historically experienced. As it turned out, those expectations were unrealistic. The result was that TIPs bonds purchasers did very well. 2009's environment is moving towards the opposite. TIPs bonds are pricing in real returns that are significantly under those experienced. Caveat emptor.

Is there a way to make a counter purchase? One candidate to consider is the International Oil Company (IOC). IOCs have profitability dominated by the price of crude oil. Crude oil prices tend to rise at times of expansion and/or dollar declines. So, intuitively, it is logical to think that at times of rising growth expectations, IOCs would be high while TIPs returns would be low. Conversely, at times of declining growth expectations, IOCs would be low while TIPs returns would be high. The following chart looks at this: