The old-fashioned roller-coaster is probably the most over-used metaphor in financial journalism. Yet in seeking to describe the volatility of the international capital markets over the last few months none other will do. Although something like stability has returned to the international debt markets over the last two months, few dare to predict it will last.

After having lunged downwards last autumn in the wake of the Russian debt default, the international debt markets appear to have retrieved a more realistic equilibrium since February. But there is plenty of evidence, including signs of an economic recovery in Asia, to suggest they could be gathering steam for the next ascent.

Equally, should you focus on the supposed over-valuation of the US stock market, the bond markets could be preparing for another descent triggered perhaps by a rise in US interest rates later this year. Whichever your preference, perhaps the least plausible scenario is that the international bond markets persist at their current reasonable valuations for long.

In seeking - albeit with waning ardour - to reform the world's so-called "financial architecture", international leaders have implicitly recognised the inherent instability of the global capital markets. This has been most dramatically manifested in emerging market debt prices - with the average spread of emerging market bonds fluctuating from 330 basis points over US Treasury bonds to almost six times that level within a frighteningly short time-span last year.

But it has also been felt across all types of market from inter-bank lending to project finance and stock market valuations. Even western government bond markets have been caught up in the lurch from one extreme to another.

For the time being, however, calm prevails. Perhaps the most notable island of stability is within the euro-zone in the aftermath of the launch of the single currency. Helped by the smooth transition to the euro and the reduction in euro-zone interest rates to 2.5 per cent, European companies have been flocking to the bond markets. Although bond prices have not rallied dramatically, the volume of new bonds denominated in euros has exceeded all expectations. In fact, at almost E200bn so far this year, bonds issued in euros have roughly equalled those denominated in US dollars since 4 January. And this is in spite of the marked absence of US and Japanese investors from the euro-denominated bond markets: they have been kept at bay by the steady depreciation of the euro against the dollar.

Indeed, one of the reasons for the quick recovery of Europe's bond market from last year's dramas, is that it is as much structural as cyclical forces that are driving it. US investment banks have long predicted that the creation of a single currency would stimulate the development of a dynamic single capital market in Europe. This is because a single currency would enable stock market investors to look at European banks and companies on a sectoral as opposed to a national basis and dump shares in those which failed to achieve acceptable returns on their equity.

Thus banks - and the companies they serve - would be under pressure to re-evaluate their traditional relationships and look more explicitly at the bottom line. For the banks this means cutting down on old-fashioned lending, and focusing more on investment banking and structured finance - the types of activity that produce higher margins. For the companies, it means tapping a more diversified source of funding, including going to the bond markets which, unlike the banks, offer both fixed-rate and long-term finance.

There has been much in the last few months to suggest this prognosis was correct. "We are seeing a profound shift in the way European banks and companies treat the financial markets," says Edson Mitchell, head of European capital markets at Deutsche Bank. "If anything, the creation of a deep and liquid bond market is happening more quickly than anticipated."

Paul Hearn, head of debt capital markets at J.P. Morgan, points out that the abolition of 11 currencies has paradoxically boosted European demand for the dollar. This is because European pension and insurance funds need to look further afield to diversify their currency holdings. Thus the volume of debt issued by European companies in both their own currency and in dollars has surged to meet growing European demand for such paper.

The disappearance of so many currencies has also compelled European investors to look elsewhere for the yields to which they are accustomed.

Instead of investing in a portfolio of government bonds and hoping the currency movement will be favourable, investors have been forced to buy riskier, higher-yielding credits, such as corporate bonds. The same logic has also fuelled demand for more complex types of security, such as asset-backed bonds, which are secured against future income streams such as mortgage repayments, credit card receivables and even unpaid social security contributions. "Two years ago few European investors would have bought a 10-year bond issued by a single A-rated company," says Mr Hearn. "Now bonds like this are sold every day."

But investors are also becoming more choosy. Both European and US investors experienced a shock last autumn when even the safest AAA-rated paper, including some government bonds, proved illiquid and thus dangerous to hold during the "flight to quality" after the Russian default. The most bizarre example of this was in the spread between so-called "off-the-run" and "on-the-run" US Treasury bonds - this despite the fact that both types of security had the same credit quality and maturity. But because one type of bond would lapse on maturity and the other would be replenished, the spread widened.

The world's largest borrowers have taken note of the "liquidity premium" and have thus been amending the way they borrow. From emerging market governments to European companies, borrowers have been issuing larger - and therefore more liquid - instruments over the last few months. The most notable example of this was when the US Federal Mortgage Association - or "Fannie Mae" as it is widely known - exchanged $15bn worth of small and illiquid notes for large-scale new bonds earlier this year.

Others, including the Dutch government and the European Investment Bank, are doing likewise. The average size of eurobond issues has nearly doubled to almost E1bn this year as a result.

The surge in demand for the type of security that can be easily bought and sold in even the most extreme conditions suggests the markets are adjusting to cope with future swings in sentiment. Can the same be said for the legislators? The International Monetary Fund has been ruffling feathers by suggesting that the covenants on emerging market sovereign bonds be altered to make it easier for the borrower to restructure payments in the event of a crisis. This is designed to "bail in" private investors to public debt work-outs and, it is hoped, curb some of the volatility in the global bond markets.

Coming so early on in the putative recovery of emerging market economies (and their bond spreads), the suggestion has upset many investors. Would Brazil, they ask, have been able to return to the bond markets with its $3bn offering last month if the offering had included such a clause? The answer is probably "yes" but at a higher rate of interest. More importantly, however, such a clause could price the most wobbly economies, such as Ukraine and Pakistan, out of the market altogether. This, say international officials, might be no bad thing if it forced such countries to develop their domestic capital markets.

But regardless of how widely such a change is implemented, it would be unlikely to curb the volatility of cross-border capital flows dramatically. Until - if ever - a way is found to separate long-term investors from the class of leveraged and speculative short-term investors who wrought such havoc last autumn, bond markets will continue to be lively places. Borrowers and investors, in other words, should continue to look for ways of anticipating the next lurch - because the rollercoaster never stops when you want to get off.


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