The Iran war and lingering trade tensions could dent euro zone economic growth, push up borrowing costs and challenge some member states’ ability to sustain public budgets, a European Central Bank report concluded on Wednesday.
Financial markets have mostly shrugged off the war in Iran, leaving stocks at rich valuations, corporate borrowing costs low and the spread between sovereign bond yields across the 21-nation bloc at low levels, raising fears that investors may be complacent about risks.
“A scenario of notably weaker growth associated with a more persistent energy shock could trigger a reassessment of fiscal sustainability and an abrupt repricing in sovereign bond markets,” the ECB said in a biannual Financial Stability Report.
Such a repricing could then raise corporate borrowing costs, setting off a feedback loop that could endanger financial stability and hit the real economy.
This risk is especially acute because governments are already financing a long list of urgent projects, limiting their fiscal buffers and their room to manoeuvre.
“High sovereign financing needs related, among other things, to defence spending, the green transition and potential fiscal measures to cushion households and firms from rising energy prices, are likely to add to pressures over the medium term,” the ECB added.
Compounding this issue is the increasing exposure of hedge funds in government bond markets. While their presence increases liquidity in normal times, hedge funds are often highly leveraged, making price movements more sensitive to changes in sentiment, the central bank said.
Any selloff in debt markets may also be exacerbated by relatively opaque non-bank financial intermediaries, which tend to be less liquid, carry greater leverage and enjoy more relaxed regulation.
Such intermediaries have widespread ties with more traditional lenders and could infect an otherwise healthy bank sector, the ECB argued.
“The potential for these highly interconnected risks to materialise simultaneously, possibly amplifying each other further, increases the risks to financial stability,” the central bank said.
Pointing to another such interconnection, the ECB also warned that concerns over debt sustainability in the U.S. could infect Europe.
U.S. Treasuries have been a safe haven but concerns over the credibility of U.S. budget policies could lead to an abrupt change in perceptions, which would then have a global impact.
The ECB also noted that markets are signalling concerns about the increased reliance of AI-related firms on debt financing, which warranted attention.
(Reporting by Balazs Koranyi)
