Will the Fed Hike Rates Consecutively? Will the Late-1980s Tightening Cycle Repeat?

Original title: "Will the Fed Hike Rates Consecutively? Will the Late-1980s Tightening Cycle Repeat?"
Original source: Wallstreetcn

A Citigroup report notes that the current macro environment is highly similar to the 1988-1989 tightening cycle, when the economy remained resilient, inflationary pressures gradually built up, and policy only turned accommodative after economic activity slowed. During that tightening cycle, the Fed raised rates 16 consecutive times. Market concerns about the Fed resuming rate hikes are heating up, bringing a cautionary historical episode back into investors' focus. Citigroup Research's latest quantitative macro strategy report shows that the similarity between the current macro environment and the 1988-1989 tightening cycle has risen significantly, and with the renewed escalation in the Middle East and rekindled US inflation pressures, the logic of cross-asset allocation is quietly shifting.

According to Wind Trading Desk, Citigroup Research analysts Alex Saunders and Vinh Vo noted in a report released on September 11 that although their macro model (Regime Model) overall remains in the "Normal" range, strengthening inflation momentum, a mild pullback in the economic surprise index, and slightly tighter financial conditions are causing the model's identified historical analogues to shift toward 1988-1989.

Notably, during the tightening cycle from March 1988 to May/June 1989, the Fed raised rates a total of 16 times. According to a tally by TF Securities' Sun Binbin team, in March 1988, the Fed chose to tighten preemptively to prevent a return to high inflation. On March 30, 1988, the FOMC meeting raised the federal funds rate by 25bp to 6.75%, and thereafter raised rates 16 times in total, ultimately lifting the federal funds rate target to 9.8125%, a cumulative increase of 331.25bp.

The typical characteristics of the late 1980s were: the economy remained resilient, inflationary pressures gradually accumulated, ultimately prompting the Fed to keep raising rates, and only after economic activity slowed did policy turn accommodative. The report also lists 1976-1977, 1996-1997, and 2013-2014 as other reference historical periods.

At the asset allocation level, this macro backdrop drives the model to further increase risk assets and establishes a clear structural preference: long emerging markets and US equities, long Japan and UK duration, while maintaining the maximum short position in US investment-grade credit, long commodities centered on energy, and shifting to a preference for the US dollar.

The 1988-1989 Tightening Cycle Returns to Focus

"Fed whisperer" Nick Timiraos wrote in his latest article that investors have largely concluded the Fed will raise rates next week for the first time in three years, and the harder question is what comes after. Since the 1990s, the Fed has only had one "one-off" rate hike.

Citigroup Research's historical analogue analysis also shows that 1988-1989 has become significantly more prominent this month. The report describes this period as exhibiting a combination of economic resilience and inflationary pressures—precisely the combination that prompted the Fed to keep tightening monetary policy in 1988 until economic activity slowed the following year, after which it shifted to rate cuts.

This is highly consistent with the current macro state. The model shows that economic growth indicators have improved moderately, the average PMI z-score remains at a strong level, and although the economic surprise index has pulled back slightly, its absolute level remains positive; at the same time, inflation momentum has picked up over the past month, financial conditions have tightened slightly, and overall remain about 0.55 standard deviations below the long-term average. The report characterizes the current macro state as exhibiting symptoms of an "overheating economy"—both growth and inflation indicators are slightly above long-term averages, but have not yet triggered a model regime switch.

The report also retains three other historical reference periods: 1976-1977 (pre-Volcker era, with declining inflation and loose financial conditions coexisting, initially supporting equities but subsequently seeing a sharp rise in inflation and policy rates); 1996-1997 (early internet expansion); and 2013-2014 (Fed tapering expectations driving a repricing of US rates). Notably, last year's tariff shock no longer constitutes a meaningful historical analogue in the latest model, which Citigroup Research believes reflects that cross-asset long-term volatility remains relatively low.

Model Stays in "Normal" Range, Equity Allocation Further Increased

Despite rising market concerns about rate hikes, Citigroup Research's K-Nearest Neighbors (KNN) model remains in the "Normal" range and has not switched to the "Tightening Financial Conditions" range. The report notes that after this month's update, the model has further raised the equity overweight from 2.8% to 4.0%, while bonds and commodities maintain positive allocations (though trimmed), and the credit short position remains unchanged.

The report also flags a potential downside path: if the energy shock persists as a sustained theme—whether driven by restocking demand or supply flow disruptions—tightening financial conditions and widening credit spreads could become the transmission chain toward a stagflation scenario.

In terms of historical Sharpe ratio performance under different models, asset performance in the "Normal" range is similar to the unconditional historical average, with bonds having a slight edge, and US equities having a certain advantage over other regions.

Cross-Asset Allocation: Energy Leads, Dollar Replaces Yen as Preferred Currency

In terms of specific asset allocation, Citigroup Research's model presents a highly differentiated structure. In equities, emerging markets receive the highest allocation, US equities maintain a small long position, while European, Japanese, and UK equities are shorted.

In rates, bonds are overall overweight by 3.7%, with Japan and UK duration receiving the largest long positions, US Treasuries being maximally shorted, and European bonds slightly shorted. This allocation logic is partly related to the hawkish forward guidance after the ECB rate hike and the rising risk premium on French government bonds.

In commodities, energy is currently the asset with the strongest expected performance, and the model concentrates its overweight in energy, supplemented by a small long in base metals and a small short in precious metals. The report notes that energy's advantage in relative carry far exceeds other commodity subcategories, while the carry for base metals and precious metals is clearly negative.

In foreign exchange, the report notes that market enthusiasm for the yen has clearly faded, with expected Sharpe ratios for the pound, yen, and euro against the dollar all negative, making the dollar the current preferred currency. This shift partly stems from US Treasury Secretary Bessent's remarks on Japan intervention, as well as the weakening momentum after the yen's phased appreciation driven by market expectations of earlier and faster tightening by the Bank of Japan (BoJ).

Trend-Following Strategies Maintain Positive YTD Returns, Systematic Strategies Diverge

From the perspective of quantitative strategy performance, trend-following strategies recorded positive returns over the past month, with strong gains in commodities and bonds sufficient to cover losses in equities and a roughly flat contribution from FX. Notably, bond trend-following strategies completely reversed their previous year-to-date negative returns this month, pushing the composite strategy overall into positive territory. Commodities remain the largest year-to-date contributor, while equities are the weakest.

Carry strategies posted a positive composite performance over the past month, with commodities and bonds contributing the main returns, while FX and equity carry were under pressure. The report also notes that commodity value strategies have continued to lead year-to-date, but equity and bond value strategies remain in negative territory, and with the renewed escalation in the Middle East driving a market repricing of inflation and policy risks, bond value strategies have weakened further.

In terms of CTA positioning, credit maintains the largest long position, while equity and commodity longs have been trimmed to near neutral.