Current Market Risk Is About Capital Flight

 |  Includes: DIA, FXE, KBE, QQQ, SPY, UUP
by: Carlos X. Alexandre

I’ve been “advertising” the concept that the European Central Bank is truly concerned about capital flight out of the euro, not inflation, and rate increases were designed to attract depositors. After all, inflation is the least of its worries when deflationary forces are in play, and a meager 1.5% minimum rate (equivalent to the Fed Funds rate) has no effect on commodity driven inflationary pressures.

In addition, irrelevant talk of the demise of the dollar continues unabated which is purely driven by emotion, and the constant talk of a new reserve currency drives the point home. Free markets will determine the end result.

But the “capital flight” issue has not been acknowledged by anyone in official circles for obvious reasons. However, Bloomberg’s article “Deposit Flight at European Banks Raises Risks” sheds some light on the issue.

Retail and institutional deposits at Greek banks fell 19% in the past year and almost 40% at Irish lenders in 18 months. Meanwhile, European Union financial firms are lending less to one another and U.S. money-market funds have reduced their investments in German, French and Spanish banks.

But the problem is not unique to the periphery and even the healthier countries are experiencing the phenomenon.

In Germany, deposits by financial institutions, which account for one-third the total, declined 12% over the same period and 24% since the September 2008 collapse of Lehman Brothers Holdings Inc., ECB figures show. In France, where the erosion started last year, the same type of deposits, which make up half the total, are down 6% since June 2010. They have fallen 14% since May 2010 at Spanish banks, where they account for one-fifth of the total.

So where’s the money going? The Telegraph may have part of the answer in its article “Central bank flight to Federal Reserve safety tops Lehman crisis.”

Central banks and official bodies have parked record sums of dollars at the U.S. Federal Reserve for safe-keeping, indicating a clear loss of trust in commercial banks. Data from the St. Louis Fed (graph below) shows that reserve funds from "official foreign accounts" have doubled since the start of the year, with a dramatic surge since the end of July when the eurozone debt crisis spread to Italy and Spain.

Click to enlarge

Click to enlarge

As The Telegraph points out, the amounts may be small, but “they serve as stress indicator, reflecting the operating decisions of the world's top insiders.”

Some say that Europe is not another “Lehman moment,” but the data may be saying something else and, unlike opinions, capital flows are pretty good indicators. And while the ECB states that the European banking system is sound, the institution is keeping a few chips out of harm’s way for a stormy day.

This afternoon MarketWatch reported that "leaders of France, Germany and Greece agreed Wednesday that Greece will remain in the eurozone," and a sigh of relief was heard throughout the globe. Let's see if there is a reversal of capital flows to match the rhetoric.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.