European Central Bank Governing Council member Fabio Panetta highlighted risks to financial stability from escalating energy market tensions tied to the U.S.-Israeli conflict with Iran.

Speaking at a conference in Rome, Panetta noted that shifts in global investor risk perceptions could pressure government bonds, particularly in high-debt economies like Italy. He pointed to early indicators such as a stronger dollar, rising long-term interest rates, and capital outflows from emerging markets as signs of a flight to safer assets.

Eurozone inflation climbed to 2.5% in March from 1.9% the prior month, driven by surging energy prices. Panetta described this as evidence of the rapid transmission of the energy shock, with effects likely persisting. Leading indicators, including falling household confidence, suggest a potential economic slowdown.

Panetta cautioned about liquidity and leverage in non-bank financial institutions, amid investor worries over the U.S. private credit sector. Even if the Gulf conflict ends soon, he added, energy supply normalization might not occur until late 2026 or 2027 under ECB's more pessimistic scenarios.

Market participants are adjusting to the outlook. BlackRock's Tactical Opportunities Fund has expanded short positions in German government bonds—covering five-, ten-, and 30-year maturities—anticipating higher funding costs from inflation and increased government spending.

Fund manager Tom Becker expects European governments to boost outlays for energy support and military needs, swelling bond supply. He forecasts German 10-year yields exceeding last week's 3.13% peak, as investors demand higher returns amid inflation above targets and reliance on the Strait of Hormuz for energy.

This view aligns with broader concerns that Europe remains vulnerable, potentially repeating fiscal expansions seen during the 2022 Ukraine crisis that widened deficits.

Despite the challenges, Panetta and Italian Foreign Minister Antonio Tajani indicated Italy is better positioned than in 2022, thanks to improved perceptions of its public finances. Panetta credited this for shielding the country so far.

Italy's measures to ease consumer energy bills, alongside expected EU-wide responses, underscore the policy focus on mitigating the shock's impact.