Financial Stability Report—2026
The war in the Middle East has led to periods of increased volatility and reduced liquidity in certain markets, particularly in energy. Nevertheless, markets have generally remained resilient. Equity valuations are still elevated, and credit spreads are compressed.
Financial markets have been hit by a series of shocks over the past 12 months. While markets have generally continued to function well, some vulnerabilities have grown.
Equity and corporate debt valuations appear increasingly stretched compared with historical levels. When asset valuations are stretched, there is an increased likelihood of a sharp correction if a shock occurs. Sovereign debt levels are also rising. A sudden shift in demand for sovereign bonds could have significant implications for the financial system.
Given the volatile environment—including the war in the Middle East, the unpredictability of US trade policy and the potential for artificial intelligence (AI) to disrupt existing business models—the risk of shocks remains elevated. Growing vulnerabilities could amplify the impacts of these shocks.
Financial market vulnerabilities
When asset prices are high relative to economic fundamentals or historical norms, asset valuations are considered stretched. This makes them more likely to fall sharply if investors reduce their appetite for risk or if their earnings expectations are revised down.1 Price declines could be magnified if leveraged investors face significant losses or margin calls that cause them to suddenly unwind their positions.
Valuations in equity and corporate bond markets—already elevated at the time of the previous Report—have continued to rise over the past 12 months (Chart 1). For example:
- The equity risk premium of the TSX compressed further, falling to the second‑lowest percentile of its recent historical distribution,2 while the risk premium of the S&P 500 remained at the fifth‑lowest percentile.
- The forward earnings yield of both the TSX and the S&P 500 declined over the past 12 months after share prices rose more rapidly than corporate earnings expectations. This is despite the fact that corporate earnings expectations are well above historical averages—17% for the S&P 500 and 25% for the TSX over 2026.3
- Investment‑grade credit spreads compressed, falling to the lowest percentile in both Canada and the United States. High‑yield spreads also became more compressed in both countries.
Heightened asset valuations are increasingly concentrated in a small number of sectors, particularly in the United States. The S&P 500’s information technology (IT) sector now accounts for nearly the same share of the S&P 500’s total market value as it did at the peak of the dot‑com bubble (Chart 2).
Because large technology firms increasingly rely on borrowing to finance data centres, corporate debt issuance is also becoming more concentrated in the IT sector. Over 18% of US investment‑grade bond issuance in 2026 has been in the technology sector—its highest level in at least 16 years. This concentration means that a decline in earnings or earnings expectations for this sector could have a significant impact on the broader market.
Sovereign debt term premiums continue to increase
Globally, government deficits have grown in recent years, and in some countries net debt is already larger than gross domestic product (Chart 3). A range of factors—including aging populations and increased defence spending—suggest that government debt loads will continue to expand. In some countries, those debt loads will have to be serviced by a shrinking population.
Because government deficits have grown, investors have had to absorb more debt issuance. These investors face funding and balance sheet constraints, so they have demanded increased compensation, pushing interest rates higher. This has been one driver of the rise in long‑term bond yields in recent years (Chart 4).4
Hedge funds have played an important role in absorbing this rising issuance of sovereign debt. Hedge funds tend to use short‑term borrowing, which increases the risk that they could pull back abruptly, particularly if liquidity deteriorates or they are forced to reduce leverage. Because sovereign bonds underpin financial markets—as key benchmarks, sources of high‑quality collateral and safe assets—any disruption can quickly spill over, reducing liquidity, straining funding markets and pushing up borrowing costs.
In the extreme, a sudden increase in government yields could trigger a liquidity spiral or the type of market turmoil seen in some government bond markets in recent years5 (see In focus: A resilient repo market is important for financial stability).
Some sectors have been affected by recent bouts of volatility
Recent events have led to strains in some markets. These include:
- The stocks of some software companies, as well as broader software equity indexes, have been negatively affected by concerns around potential disruptions from AI. These concerns have also led to a substantial widening of the spreads on leveraged loans to the software sector, and there have been outflows from private credit funds exposed to that sector (see In focus: Rapid growth in private credit has created vulnerabilities).
- Traditional safe‑haven assets have not behaved as reliably as they have in the past. Government bonds have traditionally been seen as safe‑haven assets, with demand rising during periods of market stress. But recently, bond and equity prices have become increasingly positively correlated, which has reduced the risk‑mitigation benefits of portfolio diversification.6 During market corrections, this could lead to greater portfolio volatility and forced deleveraging.
- At the start of the war in the Middle East, significant volatility led some globally active hedge funds to rapidly reduce their leverage and sell government bonds. At the same time, the potential inflationary impact of higher energy prices led to an increase in market expectations for central bank policy interest rates. This caused liquidity in bond markets to deteriorate, leading to short‑lived periods of strained market functioning.
Nevertheless, markets displayed resilience and, after volatility subsided, liquidity quickly returned to normal levels.
Endnotes
- 1. See International Monetary Fund, “Chapter 1: Shifting Ground beneath the Calm: Stability Challenges amid Changes in Financial Markets,” Global Financial Stability Report: Shifting Ground beneath the Calm (October 2025).[←]
- 2. For more details on this model, see J.‑S. Fontaine, G. Ouellet Leblanc and R. Shotlander, “Canadian stock market since COVID‑19: Why a V‑shaped price recovery?” Bank of Canada Staff Analytical Note No. 2020‑22 (October 2020).[←]
- 3. The data for both the TSX and S&P 500 come from London Stock Exchange Group’s Refinitiv Workspace and Bank of Canada calculations.[←]
- 4. For more details, see E. Trostin, J. Ketcheson and A. Diez de los Rios, “The rise in the Canadian term premium in a global context,” Sparks at Bank, Bank of Canada (March 2026).[←]
- 5. Some examples include the market for US Treasury bonds in April 2025, Japanese government bond markets in January 2026, and UK gilt markets in September 2022.[←]
- 6. For more details, see T. Adrian, J. Kramer and S. Malik, “Stock‑Bond Diversification Offers Less Protection From Market Selloffs,” International Monetary Fund IMFBlog (February 18, 2026).[←]