Global financial markets entered 2026 from a position of strength. Asset prices rose across major markets, volatility was subdued, and financial conditions were easy by historical standards. That benign backdrop has now been tested by the war in the Middle East.
So far, markets have absorbed the shock with a degree of resilience. While the decline in asset prices has been significant, market functioning has been orderly. Nonetheless, this resilience should not be taken at face value. Rather, it reflects cycles of escalation and de-escalation, structural improvements in the financial system, and the absence of a decisive adverse turn that would trigger sustained market drawdowns.
Repricing, orderly market functioning
Global markets reacted swiftly following the outbreak of hostilities. Equity prices declined, sovereign bond yields rose, and volatility increased across asset classes, reflecting higher energy prices and renewed inflation uncertainty. Importantly, this adjustment was reasonably orderly, without signs of acute liquidity stress or funding problems among financial institutions and investors.
In fact, this price‑based absorption of shocks is a key feature of resilient markets. It facilitates risk sharing across investors and preserves price discovery critical for efficient capital allocation. So far, short‑term funding markets and core market infrastructures have helped facilitate the repricing of assets.
Financial conditions have tightened since the onset of the conflict, but they remain far from the stress levels observed during past episodes of global turmoil. Compared with earlier crises, there is still a considerable margin of safety. At the same time, the relatively modest adjustment to date also indicates that markets have not fully priced adverse scenarios.
Inflation as a transmission channel
The main channel through which the conflict has affected markets has been via inflation expectations. Higher energy prices have pushed breakeven inflation rates and yields up across advanced and emerging economies. Yield curves have flattened, with short‑term rates rising more than long‑term rates.
This highlights the difficult environment facing central banks. With near-term inflation risks having risen substantially, monetary policy must remain focused on price stability. On the other hand, the longer the war continues, the more damaging it is to economic growth and labor markets—the flattening of the yield curve, should it continue, could be a sign of this. In this environment, clear communication, credibility, institutional independence, and timely tightening when warranted are essential to anchoring expectations.
Spotlight on emerging financial vulnerabilities
Higher yields have renewed focus on public debt risks. Many advanced economies are entering this episode with elevated debt levels and limited fiscal space. Together with changes in the investor base—away from central banks and toward price‑sensitive nonbank investors—sovereign yields may respond more forcefully to inflation shocks than in the past.
Emerging markets are more sensitive to these changes. Elevated pre‑shock valuations and the growing dominance of debt portfolio flows and carry‑trade strategies have increased exposure to global risk sentiment. While resilience has improved over the past decade in many countries, vulnerabilities remain pronounced in those with high external financing needs or volatile investor bases.
Amplification mechanisms
The key financial stability risks do not lie in the initial shock itself, but in amplification channels that could turn market volatility and sell-offs into more acute stress. Elevated leverage in parts of the nonbank financial sector, increased concentration in equity markets, and historically tight credit spreads all raise the potential for abrupt forced-selling and sudden liquidity strains through margin and collateral calls.
Private credit is an important area of focus. Rapid growth in direct lending has made the sector more important to the overall economy and financial system, while opacity, valuation practices, short‑term funding backed by longer‑term assets, and rising defaults pose challenges. While these vulnerabilities have not yet been tested by an adverse shock, their presence means that the system is more exposed, even if markets have remained orderly so far.
Policy space: constrained, but differentiated
In addition to monetary policy, other key policy areas also have uneven space to act. Fiscal policy is limited by high debt and persistent deficits. By contrast, financial stability policy is less constrained. Central banks have reduced their balance sheets, freeing some capacity for asset purchases if needed, and crisis‑management frameworks and liquidity backstops are stronger than in the past. Targeted prudential measures, robust supervision, effective stress testing, and well‑designed liquidity tools can also be deployed.
Prepare, don’t predict
The experience of recent months underscores that resilience should not be inferred from the absence of stress. Elevated asset prices, intact risk‑taking incentives, and stronger amplification channels mean that risks remain skewed to the downside—even if markets have adjusted in an orderly manner so far.
The task for policymakers is therefore not to predict the next shock, but to ensure that vulnerabilities are mitigated and the system remains capable of absorbing stress without amplifying it. Amid recurring supply shocks and heightened geopolitical uncertainty, financial stability cannot be taken for granted—it must be actively protected.
—This blog is based on Chapter 1 of the April 2026 Global Financial Stability Report, “Global Financial Markets Confront the War in the Middle East and Amplification Risks.”
