The European Central Bank stated on Wednesday that investors are underestimating various risks stemming from the Middle East conflict and rising government debt.
In its semi-annual financial stability review for the eurozone, the ECB noted that while the market's reaction to the conflict has been generally stable, it still exhibits a sense of complacency amid heightened uncertainty about the economic outlook.
The ECB Vice President said: "Although financial asset prices initially fell, they remain high compared to historical levels. When combined with current geopolitical economic pressures and uncertainty, the overvaluation problem becomes more pronounced. This makes the market highly vulnerable to significant price reassessments."
Following strikes by the US and Israel against Iran in late February, European government bond prices fell. This week, however, expectations for a peace agreement have emerged, with hopes of reopening shipping in the Strait of Hormuz and restoring regional energy supplies, allowing bond prices to recover some of their losses.
The ECB warned that if these hopes are dashed and the conflict escalates further or becomes protracted, market concerns about the fiscal positions of various countries will intensify, damaging financial market sentiment and potentially triggering large-scale sell-offs, exposing vulnerabilities in sovereign debt.
High energy prices are weighing on economic growth, and the tax revenues projected in eurozone countries' 2026 budgets are likely to fall short of expectations. Meanwhile, rescue needs from households and businesses could push up fiscal expenditures. These dual factors may lead to a widening of fiscal deficits and a further decline in government bond prices.
The ECB stated: "If energy supply disruptions persist and economic growth weakens significantly, market participants may reassess sovereign debt risks."
The central bank also pointed out that developments in the US Treasury market are a significant source of risk. Over the past decade, the growth rate of US government debt has far exceeded that of European countries.
"Persistent high fiscal deficits, expectations of rising debt servicing costs, and substantial financing requirements have led markets to question US fiscal credibility. This could alter global risk appetite and subsequently trigger a reassessment of sovereign debt prices worldwide."
The ECB noted that eurozone government bond prices also face other external pressures. Driven by expectations of higher inflation and increased government bond issuance, Japanese government bond yields have risen sharply in recent months and are now approaching levels seen in other regions.
"This could prompt a shift in global portfolios towards Japan, reducing Japan's demand for foreign bonds and consequently pushing up bond yields globally, including in the eurozone."
As long as shipping through the Strait of Hormuz is disrupted, oil and gas revenues for Middle Eastern countries will shrink, which would also weaken their purchasing power for eurozone government bonds.
The ECB stated: "Geopolitical changes will reshape global capital flows, and the pattern of reinvesting oil revenues will also change accordingly."
Changes in the composition of the investor base for government bonds could exacerbate price volatility. In recent years, the ECB has exited its bond-buying program, and pension funds, which tend to hold bonds to maturity, have seen their market share decline steadily.
Hedge funds have gradually become a dominant force in the market. These institutions typically use leveraged funds and are more sensitive to price fluctuations.
The ECB said: "Hedge fund trading strategies are highly responsive to price changes, and some trades are leveraged, making market pricing more susceptible to sentiment."