Many analysts believe that the development is the strongest signal yet that the world economy is on the brink of a recession.

The drop in interest rates on long-term government bonds means that the markets are betting that future inflation rates will stay down at unprecendently low levels.

It is a gamble that recession, rather than inflation, is the main threat.

Flight to quality

The collapse in bond yields has accelerated in the last few weeks as investors have sought safe havens from currencies and stock markets under threat.

The greater demand for bonds has pushed up the prices, effectively lowering the interest payable on them.

But now the rush to buy bonds has pushed yields to record lows.

The US 30-year Treasury bond has moved to just above 5.16%, its lowest level ever, and German 10-year bunds are under 4%, while Japanese 10-year bonds are 0.7%.

Since investors usually want a real return of at least 3-4%, this implies that they believe inflation will be around 1% in Germany and the USA, and negative in Japan.

In contrast, bond yields in emerging markets are 18% higher on average - up from a difference of 6% a few years ago.

Deflationary worries

The development is good news for governments, who have to pay less interest on their debts. But it is worrying some analysts, who fear that it signals a severe deflation.

For most of the post-war years, we have lived with varying degrees of inflation., with prices increasing every year.

Although we have worried when prices got too high, our system is geared for some degree of inflation - most people who borrow money to buy their house are betting on some inflation, for example.

True deflation - with falling commodity prices, weak demand, and high unemployment - last occurred in the l930s, when the world entered the Great Depresssion.

Some analysts think that such a time is not too far away.

"If there is another Russia the West could be peering into the abyss of global deflation," commented Avinash Persaud head of currency research at J.P. Morgan.

Inverted yield curve: rate cuts?

Another worrying feaure of the drop in bond yields is that they have taken long-term interest rates below the short-term rates set by Central Banks.

Normally long term interest rates are higher, because of the concern that inflation would eat away at the value of money held for a long time.

An inverted yield curve, where short-term rates are higher, are normally a sign of an impending recession.

They also suggest that a reversal in policy by central banks is imminent, lowering short-term rates to bring things back into balance and stimulate the economy by making it cheaper for companies to borrow.

But at present a number of central banks are not in a position to lower rates.

Germany's Bundesbank, facing the prospect of lowering rates across Europe in advance of the single currency, is in no position to make further rate cuts.

And Japan's central bank has already cut interest rates to 0.25%. That leaves any action on rates to the US Federal Reserve Bank, which next meets on September 29.