Keeping it simple

The model is deceptively simple. It incorporates two variables: short-term interest-rate differentials between the U.S. and Germany, and whether the U.S. dollar is rising or falling against the deutsche mark (pre-1999) or the euro.

The interest-rate differential we calculated was the difference on three-month Libor and, then when available, the three-month futures contract for Eurodollars and Euribor.

There are four possible combinations of the two variables. The first, which we’ll call Phase I, occurs when interest rate differentials move in favor of the U.S. and the dollar weakens. Phase II arises when the dollar strengthens while interest-rate differentials continue to move in the U.S.’s favor. (We believe the dollar is currently in Phase II.)

When rate differentials begin to shift in favor of the Eurozone and the dollar remains strong, the cycle has entered Phase III. The final phase, Phase IV, occurs when the dollar weakens as the interest-rate spread continues to favor the Eurozone.
It illustrates the four phases and shows that since the late 70s the dollar has repeatedly moved in succession through these four phases.