Will the Fed "hike rates consecutively"? Will the "tightening cycle" of the late 1980s repeat itself?

Original author: Zhang Yaqi

Original source: Wallstreetcn

Mounting concerns over the Federal Reserve restarting rate hikes are bringing a historically cautionary cycle back into investors' view. Citi Research's latest quantitative macro strategy report shows that the degree of similarity between the current macro environment and the 1988–1989 tightening cycle has risen markedly, and combined with renewed escalation in the Middle East and rekindled US inflation pressures, the logic of cross-asset allocation is quietly shifting.

According to news from the Zhuifeng Trading Desk, Citi Research analysts Alex Saunders and Vinh Vo noted in a September 11 report that although their macro Regime Model overall remains in the "Normal" range, strengthening inflation momentum, a moderate pullback in the economic surprise index, and slightly tighter financial conditions are pushing the historical analog periods identified by the model 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 statistics from the team of Sun Binbin at Tianfeng Securities, in March 1988, the Fed chose to tighten ahead of time 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 hiked a total of 16 times, ultimately raising the federal funds rate target to 9.8125%, for a cumulative 331.25bp of hikes.

The late 1980s were typically characterized by resilient economic growth and gradually accumulating inflation pressures, which ultimately prompted the Fed to keep raising rates, followed by a slowdown in economic activity before policy turned accommodative. The report also lists 1976–1977, 1996–1997, and 2013–2014 as other historical reference periods.

At the asset allocation level, the above macro backdrop drove the model to further increase holdings of risk assets and established a distinct structural preference: long emerging market and US equities, long Japanese and UK duration, while maintaining the maximum weighting in short US investment-grade credit, going long commodities with energy at the core, and turning to favor the US dollar.

The 1988–1989 Tightening Cycle Returns to View

"New Fed Wire" Nick Timiraos wrote in his latest article that investors have largely concluded the Fed will deliver its first rate hike in three years next week, but the harder question is what comes after. Since the 1990s, the Fed has only once delivered a "one-and-done" rate hike.

Citi Research's historical analog analysis also shows that 1988–1989 became markedly more prominent this month. The report describes this period as presenting a combination of economic resilience and inflation pressure—precisely the combination that prompted the Fed to keep tightening monetary policy through 1988 until economic activity slowed the following year, after which it pivoted to rate cuts.

This aligns closely with the current macro state. The model shows that growth indicators are improving modestly, the average PMI z-score remains at a strong level, and although the economic surprise index has edged lower, 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 they remain about 0.55 standard deviations below the long-term average. The report characterizes the current macro state as showing "overheating" symptoms—both growth and inflation indicators are slightly above their long-term averages, but not yet enough to trigger a model regime switch.

The report also retains three other historical reference periods: 1976–1977 (the pre-Volcker era, when disinflation coexisted with accommodative financial conditions, initially supporting equities but followed by a sharp rise in inflation and policy rates); 1996–1997 (the early internet expansion); and 2013–2014 (when expectations of Fed tapering drove a repricing of US rates). Notably, last year's tariff shock no longer constitutes a meaningful historical analog in the latest model, which Citi Research attributes to long-term cross-asset volatility remaining at relatively low levels.

Model Holds in "Normal" Range, Equity Positioning Raised Further

Despite rising market concerns about rate hikes, Citi Research's K-nearest neighbors (KNN) model remains in the "Normal" range and has not switched to the "tightening financial conditions" regime. The report notes that after this month's update, the model further raised its equity overweight from 2.8% to 4.0%, kept positive allocations to bonds and commodities (though reduced), and left credit short positions 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—tighter financial conditions and wider credit spreads could become the transmission chain toward a stagflation scenario.

In terms of historical Sharpe ratio performance across different models, asset performance in the "Normal" range is close to unconditional historical averages, with bond characteristics holding a slight edge, while US equities have a certain advantage relative to other regions.

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

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

On rates, bonds are overall overweight at 3.7%, with Japanese and UK duration receiving the largest long allocations, US Treasuries maximally shorted, and European bonds slightly shorted. This allocation logic is partly related to the ECB's hawkish forward guidance after rate hikes and the rising risk premium on French government bonds.

On commodities, energy is currently the strongest expected-performing asset, with the model concentrating 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 terms of relative carry far exceeds that of other commodity sub-sectors, while the carry for base metals and precious metals is clearly negative.

On foreign exchange, the report notes that market enthusiasm for the yen has faded markedly, 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 intervention in Japan, as well as weakening momentum after the yen's periodic appreciation driven by expectations that the Bank of Japan (BoJ) will tighten policy earlier and faster.

Trend-Following Strategies Remain Positive YTD, Systematic Strategies Diverge

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

Carry strategies delivered positive composite performance over the past month, with commodities and bonds contributing the bulk of returns, while FX and equity carry came 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, with bond value strategies weakening further as renewed escalation in the Middle East drives markets to reprice inflation and policy risk.

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