According to some commentators, the recent sharp fall in longer-term gilt yields signals that investors expect the UK to follow Japan into deflationary stagnation. This is incorrect. Markets, in fact, are discounting prolonged economic weakness with continued elevated inflation.

Japanese government bond yields plunged in the 1990s as investors factored in the likelihood of a sustained decline in prices, partly due to a super-strong yen. The drop in UK yields, by contrast, has been driven by lower real interest rates rather than a fall in inflationary expectations. The real yield on 10-year index-linked gilts recently turned negative for the first time since linkers were introduced in the early 1980s – see chart. Indeed, it is unlikely that investors have ever before willingly extended a long-term loan to the British state in the expectation of an erosion in the real value of their wealth.

If investors expected deflation, they would shun index-linked bonds, causing their price to fall and yield to rise. Linkers are unprotected against a fall in the price level. Deflation, moreover, would push up real yields, resulting in a capital loss.

The negative yield on index-linked gilts could indicate that investors fear an inflationary upsurge so are willing to pay a big premium for inflation protection. In this case, however, yields on unprotected conventional gilts would rise not fall. Equities and property, meanwhile, would be expected to outperform conventional bonds because they are partial inflation hedges.

The combination of falls in conventional and index-linked gilt yields with lower equity prices is consistent with investors discounting prolonged economic weakness and steady above-target inflation. Economic weakness would erode corporate profits while encouraging the Bank of England to maintain heavily-negative real short-term interest rates. Investors, therefore, expect to suffer a smaller real loss in conventional or index-linked gilts than in stocks or cash.

The implied scenario of economic stagnation with stable elevated inflation is implausible. Chronic economic weakness, historically, has been associated with either deflation or rising inflation. Linkers would do badly in the former case and conventionals in the latter. Gilt investors are irrational to bid up the prices of both. Their current schizophrenia is unlikely to last.