The bombs fell on Lebanon, and the City barely flinched. Reports are emerging of dozens dead across the country as Israeli forces intensify their aerial campaign near the border. This is not a new war. It is an escalation of a conflict that has simmered for decades. And yet, the reaction from the financial markets has been curiously muted.
Gilt yields barely budged this morning. The FTSE 100 opened flat. The pound held its ground against the dollar. To the casual observer, it might appear that the markets have developed a thick skin. But that would be a misunderstanding. What we are witnessing is not indifference but a grim discounting of risk. The market has already priced in the volatility of the Middle East. It has learned to live with the background radiation of conflict.
But let us not be fooled. The cost is being recorded elsewhere. Oil prices crept up by 2% in early Asian trading, a predictable reaction to any disruption in the region. The risk premium on Israeli bonds widened, but only marginally. The real impact, as always, will be borne by the people on the ground and by the fragile economies of Lebanon and its neighbours.
For Lebanon, the timing could not be worse. The country is already mired in an economic crisis that has seen its currency lose over 90% of its value since 2019. Inflation is running at triple digits. The banking system is in ruins. And now, its southern suburbs are being pounded by Israeli jets. The cost in human life is, of course, the primary tragedy. But the financial cost will further cripple a state that can barely function.
Investors, meanwhile, are watching the US dollar. The greenback remains the safe haven of choice. Any escalation in the Middle East tends to trigger a flight to the dollar and US Treasuries, at least in the short term. But this time, the flow has been modest. Why? Because the market is also watching the Federal Reserve. US interest rates are at a 23-year high, and the Fed has signalled it will keep them there. The carry trade is alive and well. Investors are being paid to hold dollars. That is a powerful anchor.
But here is the danger. The longer this conflict drags on, the more likely it is to spill over. A full-scale regional war would send oil prices through the roof. It would trigger capital flight from emerging markets. It would force central banks to rethink their monetary policy. Inflation, which we thought was tamed, could stage a comeback. And then the market would react. It always does.
For now, the City is calm. But do not mistake this for stability. It is a contingent equilibrium, dependent on the assumption that the violence remains contained. If that assumption is broken, all bets are off. The bottom line is that bloodshed in Lebanon adds to the risk premium of the entire region. And risk premiums have a habit of spreading.
