The European Central Bank's half-yearly Financial Stability Report May 2026 illustrates a deep gap between the skepticism of central bankers and the optimism of financial markets.
For the ECB escalating in the Middle East is a major shock of supply, which, if not immediately restored, threatens energy supply through the Strait of Hormuz, causing inflationary pressures and risk of stagnation.
The war in Iran, together with the continuing trade tensions, could therefore affect the economic development of the Eurozone, increase lending costs and make it difficult for some Member States to support their public budgets, according to the European Central Bank report published on Wednesday.
The ECB is also afraid that the high valuations of shares and the historically low spreads of corporate and government bonds suggest that investors ignore the scenario of a sharp slowdown in the European economy.
Indeed, financial markets have largely ignored the war in Iran, resulting in shares negotiating in high valuations and companies' borrowing costs remaining relatively low.
But... in a scenario of significantly weaker growth It is not possible for investors to move towards a more persistent energy shock. re-evaluation of fiscal sustainability And therefore in a a sharp valuation on the sovereign bond markets and then on the shares.
Such an appreciation could then increase the cost of lending businesses, creating a vicious circle that would threaten financial stability and affect the real economy.
This risk is of particular concern to the ECB, because at this time governments increase debt issues to finance a large part of their extraordinary expenditure, restricting their budgetary margins.
You see, defence expenditure and the green transition require large debt issues, when there is a need for increased budgetary interventions to support households and businesses from rising energy prices. This Treaty, according to the ECB, is likely to intensify pressure in the medium term.
In addition to the problem is the increasing exposure of hedge funds to sovereign bond markets. Although their presence increases liquidity in normal conditions, hedge funds often operate with high leverage, making price movements more sensitive to climate change.
A possible massive liquidation in debt markets could also be exacerbated by relatively opaque non-bank financial intermediaries, who tend to have lower liquidity, greater leverage and more loose regulation.
Such intermediaries have extensive connections with more traditional lenders and could transmit the crisis to an otherwise healthy banking sector, according to the ECB.
The ECB also warned that concerns about the sustainability of the US debt could be transmitted to Europe.
The «safe haven» American bonds are sometimes raised in doubt because of concerns about the credibility of the US budgetary policy. But this blow of trust in such a deep structure of the financial system can lead to a sharp change in investment perception and culture, which will have global implications.
In short, the growing American debt and political pressure on Fed's independence undermine long-term trust in American State bonds. If markets suddenly require a higher risk premium to lend the US, a global risk revaluation wave will be caused that will also directly contribute to European government bonds, increasing lending costs for European governments over a period of already limited financial space.
The ECB also focused on the increased dependence of Artificial Intelligence companies on lending.
Frenzy around Artificial Intelligence has led to enormous capital costs, which are increasingly funded through private credit markets – private credit – and complex forms of leverage from non-bank institutions (hedge funds etc.).
The ECB warns that if revenue from AI does not justify expectations, these highly leveraged entities will be faced with a liquidity crisis, which can be transferred to the systemic banking system through the financing interfaces.
Finally, another important concern of the ECB is that as all the above risks interconnect with each other, the possibility of them occurring simultaneously is measurable, which increases the risks to financial stability.
Why do markets ignore these dangers?
Financial markets are not blind, but operate on the basis of different incentives and instruments from the Central Banks
Historically, markets tend to treat wars as local or temporary events, unless they directly and permanently affect global supply chains. The resilience demonstrated by the world economy in both the pandemic and the war between Russia-Ukraine and the commercial wars that Trump inaugurated already since his first term, convinced investors that companies now have the flexibility to absorb shocks.
High corporate profits are a proof of this belief, while the «promise» the increase in productivity from the fifth industrial revolution keeps expectations high.
FOMO-Fear Of Missing Out syndrome has clearly played its role. The flow of funds to technology is driven by the belief that AI is a structural productivity revolution, equivalent to the Internet. At times like this, institutional investors prefer to take the risk of a bubble rather than stay out of huge returns, underestimating leverage.
As far as US debt concerns are concerned, investors anticipate that in the event of a systemic crisis, Central Banks will be forced to intervene again to support liquidity, so the risk if and when it occurs will be addressed through modern monetary instruments.
In short:
-The ECB is concerned about the risk that it will change the profile of corporate funding due to stagnation, but investors «bet» that the profitability of European companies remains robust and that companies have reduced their dependence on bank lending, turning to equity and long-term bonds.
-The ECB is concerned that risk diffusion by shadow banks threatens the system, while the investment community prefers to focus that the European banking system currently has strong capital reserves and high profitability due to previous years. So it's armored to absorb vibrations.
- The ECB is afraid that high leverage in AI creates a systemic bubble. Investors believe that AI is not just speculation. Its rapid integration in business already improves profit margins and productivity, which justifies high valuations and allows for smooth debt servicing.
– The ECB is concerned that a tsunami on the American debt market can reach Europe. Investors focus that restructuring global savings through the EU's promoted Savings and Investment Association creates new domestic mounds in Europe, keeping European spreads protected from external American turbulence.
This is why the European Central Bank is performing its institutional role by warning against the worst possible scenario. However, markets, at least for the time being, are moving on the basis of the strong fundamental size of businesses, the structural change of technology and the systemic shielding of banks.
Disclaimer of Liability: This material is provided for information purposes only. Under no circumstances should it be taken as a supply, advice or encouragement for the purchase or sale of the products mentioned. Although the information contained is based on sources considered reliable, no assurance is given that they are complete or accurate and should not be taken as such.
