The current cycle

As the Federal Reserve slashed interest rates in 2000 and short-term U.S. interest rates fell below Eurozone rates, the dollar began its cyclical decline (Phase IV), although many observers attributed the drop to worries about the current account deficit. The Fed began a gradual tightening process in June 2004, and even as interest-rate differentials widened in the second half of that year, the dollar continued to fall, which is typical of Phase I of the dollar’s cycle.

However, in the first quarter of 2005, the dollar began to find traction and trended higher as the year progressed and interest-rate differentials continued to trend in the U.S.’s direction. The dollar recorded its high for the year in the fourth quarter as Phase II unfolded.

The last phase of the dollar’s cyclical advance — Phase III — takes place as interest-rate differentials narrow against the U.S. The implied interest-rate differential between the June 2006 Euribor futures contract and the June 2006 Eurodollar peaked in mid-August 2005 near 220 basis points. The spread narrowed to the mid-180 basis point area as the market began pricing in the beginning of a tightening phase by the European Central Bank (ECB).

However, in late January the spread began widening again as the pendulum of market sentiment swung in favor of additional rate hikes by the Federal Reserve. By mid February, the spread had widened again and surpassed the mid-August peak of 220 basis points. Rather than signaling the entry into Phase III, the narrowing of the interest-rate differential from August 2005 through January 2006 appears to be counter-trend in nature — a correction, not a new trend.

Over the course of the current tightening cycle, many market participants have been repeatedly surprised by the magnitude and duration of the Federal Reserve’s action. Several times the market has gotten it into its collective head the Fed was done — including in the immediate aftermath of Hurricane Katrina, or the “one-and-done in 2006” sentiment — only to reverse itself later.