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Over the past couple of weeks, analysts have been keeping an eye on the London Interbank Offered Rate (LIBOR), which has been rising steadily. As of May 26, LIBOR for three month loans rose to 0.536%, marking the highest rate that LIBOR has hit in almost 11 months.

“Forex Gump, I don’t get know what you are talking about! What the heck is LIBOR?!?”

To borrow some words from Pip Surfer, chill out dudes and dudettes, sit back, relax, and listen to good ol’ Forex Gump giving the 411 on LIBOR.

As the name suggests, LIBOR is the interest rate that London banks charge to lend money to one another. It is the most widely accepted interest rate used for the calculation of interest rates for forwards, futures and interest rates swap contracts. Every day, at 11:00 am GMT, the BBA calculates LIBOR by getting the average of the 16 biggest and baddest multinational banks on the block. This average represents the interbank rate at which these banks can borrow from each other.

“Forex Gump, why are you talking about LIBOR? I’m a FX Trader for crying out loud!”

A rising LIBOR implies that lenders are charging higher borrowing rates to because they are less willing to loan funds to them.

Remember, like any other investors, banks will only accept to take on additional risk if they are properly compensated, i.e. more yield. With the ongoing debt crisis in the euro one, there’s a lot of uncertainty floating around, which means that lenders are tad more hesitant to take on more risk.

Will the bailout package help the euro zone get back on its feet? Or will it turn out to be a humongous bust? With that said, I think that the recent spikes in the LIBOR reflect lenders’ doubts that the funds that they are lending out can be paid back.

Looking further ahead, increasing borrowing costs could make it more difficult for European banks to secure funds, eventually paving the way for tighter credit conditions in Europe. Individuals and businesses would find it more costly to get loans, putting a strain on economic activity.

On top of that, since they incur higher interest rates, European banks would find it tougher to repay their loans. How would debt-ridden nations, like Greece and Spain, be able to trim their deficits then, eh?

Still, although LIBOR tends to spike during times of uncertainty like in the past couple of days, it always eases back near benchmark interest rates in the long term. This probably doesn’t mean much for a day trader but if you’re one of those longer-term investors, knowing the long term relationship between LIBOR and the FX market will be another good addition to your trading tools.

Just by eyeballing these two graphs below, we can deduce that there is indeed some correlation between the LIBOR and the EURUSD. Over the span of five years, we can see how the two move in tandem, rising as one rises, and falling as the other falls.

PoD Chart

PoD Chart

Of course, this has a lot to do with the relationship between LIBOR and benchmark rates. With the prospect of major central banks keeping rates low for the next couple of mounts, will we see the EURUSD continue its downward spiral?