Underpinning Europe's new bond market will be low and stable inflation and interest rates. This will help drive both bond issuance and demand for new fixed income products in Euroland.

To understand why rates won't go up, we need to look at why they rose so high in the past, and what finally brought them to earth. The prime suspect is poor monetary and fiscal policies. Policy makers in the 1970s, brought up in the Great Depression, believed they could banish unemployment by raising inflation. Further, the OPEC oil shocks hiked inflation. Finally, the key Western economy (the US) was at war, both the Vietnam War and the Cold War. And war and inflation typically go hand in hand.

In the late 1980s and 1990s inflation and interest rates fell as two key changes occurred. First, the Cold War ended. Second, there was a sea-change in economic conventional wisdom. The new credo is that if you try to lower unemployment by raising inflation, eventually what you get is the old rate of unemployment back again, but at a higher rate of inflation.

This had been argued in the late 1960s and 1970s by Milton Friedman and the 'rational expectations' school of macroeconomics, but didn't begin to affect public policy until the 1980s. Then, a new crop of central bankers and treasurers took over, drilled in the new theory and with vivid memories of the inflationary 1970s. The accepted thinking now is that monetary policy can affect inflation, but cannot affect unemployment. In contrast with their predecessors, these policy makers are more likely to err on the side of deflation.

Why will inflation stay low in Europe in particular? Under the Maastricht Treaty, the European Central Bank is the most independent central bank in the world. Central bank independence is highly correlated with low inflation. The ECB will want to prove itself a worthy successor to the Bundesbank, and so will use its first few years to establish its credibility. New central bank heads usually do this. But here we have a whole new central bank, so the effort will be exaggerated. What is more, the stability pact - EMU members must keep their deficits below 3% of GDP or face fines - means that fiscal policies cannot ignite inflation.

In this kind of world, bond yields will be relatively stable because the ECB will have established its credibility in long term inflation control. So if target inflation is 2%, and the real rate is 3%, bond yields will tend towards 5%. Even if the ECB hikes short term rates to 8%, therefore, the change will largely be confined to the short end of the yield curve because the market will expect the rise to be only temporary.

So for the foreseeable future we can expect a Europe of low and stable inflation, flat yield curves and stable bond yields.

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