Are 10 Year Rates always Inflation Expectations for Tomorrow?

An old tenet in the bond markets was that the yield on the current 10 year reflected the market's expectations for inflation in the future.

Given that a positive yield curve is viewed as "normal" one has to assume therefore that inflation is built in to the system-the question is just "how much?".

That sort of thinking is behind Mr Greenspan's announcement that there is a "canary in the mine" because the 10 Year is flirting with 4% and this is a sure sign that serious inflation is lurking just around the corner.

And of course, with all the debt issuance by the US, UK and actually the OECD it is no wonder that there are concerns about inflation. Sovereign debt in the OECD has increased from 44% of GDP in 2006 to a whopping 70% today. The Bank of International Settlements (BIS) estimates that the US,the UK and Japan would have to introduce a fiscal tightening of 8-10% a year for the next 5 years to get debt levels back to where they were in 2007!

Yesterday I discussed the concerns that China has about maintaining social stability. I shudder to think what the social stability in US and the UK would be if a such a fiscal tightening were introduced.

Look at how the Greeks have reacted to government plans to reign in fiscal spending. There has been a very quiet strike going on in Ireland for the last 6 or 7 weeks("work to rules"). In the UK the election is being fought over how the deficit can be cut without drastic fiscal tightening. Everyone talks about "efficiency savings" in the Public Sector as the way forward.

Well, the Railway signal workers of the RMT which represents the Rail, Maritime and Transportation Workers has voted to go on strike efficiency cuts as their interpretation is that this means plans to cut jobs and for more maintenance work to be done weekends.

They view these cuts as the thin edge of the wedge. They are probably right. These are the descendants of those workers in the UK who were willing to strike during WWII. (Strikes reached a highpoint in 1944 with a record 2194 stoppages with 3,700,000 days lost!)

So what happens in "peacetime" when real cuts are introduced? Or will they be? It is popular to talk about the need to cut spending, but there is a potentially massive social cost to be paid.

This is an extremely sensitive question. I mentioned a couple of days ago that US and UK sovereign debt were trading Swaps Plus. If this is really a harbinger of a repricing in sovereign debt then it is really questioning the basis of the marketplace. Sovereign debt is supposed to be "risk-free". It is what the cautious investor buys. Under the term cautious I mean such investors as pension funds, insurance funds and anyone looking for a safe, liquid investment. Under Basle I and II OECD sovereign debt has a 0% risk-weighting so it is the core investment to stabilize the banking system, especially in a positive yield curve environment.

I don't know what the answer is and I don't like to scare monger, but I am worried.