Interest Rate Swap Market Affects the Euro

An intricate relationship exists among the various financial tissues that bind and hold together the 17-nation European currency: the euro. Domestic policies of countries within the euro zone, interest rates (both European and non-European ones) and central bank policies all weigh in the scales that keep the euro in balance. Stripping away all complexity, however, the relationship really comes down to the old market rule of demand and supply.

The Interest rate swap market of the euro zone holds the number one position in the world as both the largest and most liquid one. The European markets play such a major part in fact, that the swap curves and the benchmark yield curves of the European financial markets coincide. Even government bonds sometimes use the swap yield curves as a reference point for rates.

Both the bond markets and the foreign exchange markets are highly influenced by the interest rates which is the reason why traders are advised to keep an eye on the interest rate swap market. Because European government bonds can only be purchased in euros, a high interest rate on the euro, as compared to other economies around the world, will create a demand for the euro which will ultimately send its value climbing up affecting both currency trades and the value of bond purchasing. Conversely, if interest rates on the euro lie low in comparison to other currencies, investors will look elsewhere for better opportunities with higher yield, and thus drive the demand for the euro down.

When a financial crisis or other economic instability averts investors from investments as they consider the yields not to be worth the risks the relationship between rates and yields are inverted. Therefore, during periods of European economic recession or credit contraction when investors lose faith in the euro, capital flows out of the currency and into safer investment options which pushes interest rates down. In 2008, for example, at the wake of the global financial crisis, even though European interest rates were lower than those in the U.S. (which should favour the euro), investors still flocked to the American currency on the belief that a U.S. government default on its bond purchasing was less likely than a European default, thereby causing the euro to depreciated significantly because Interbank lending levels in Europe were driven very high. Interest rates, however, can also affect euro currency rates to the degree that they affect the euro zone. Economies with a rising GDP attract more investors and speculators on the promise of an increased value of their currency as development takes hold in society.