Will the Federal Reserve raise interest rates continuously? Will the tightening cycle of the late 1980s be repeated?

Market concerns about the Federal Reserve resuming interest rate hikes are intensifying, bringing a historically cautionary cycle back into investors' view. A recent quantitative macro strategy report from Citigroup Research indicates that the current macroeconomic environment is significantly more similar to the tightening cycle of 1988-1989. This, coupled with escalating tensions in the Middle East and renewed inflationary pressures in the United States, is subtly altering the logic of cross-asset allocation.

According to TrendFocus, Citigroup research analysts Alex Saunders and Vinh Vo pointed out in a report released on September 11 that although their Regime Model remains in the "Normal" range overall, the strengthening inflation momentum, the moderate decline in the economic surprise index, and the slight tightening of financial conditions are causing the historical approximation period identified by the model to move closer to 1988-1989.

It is worth noting that during this tightening cycle from March 1988 to May/June 1989, the Federal Reserve raised interest rates a total of 16 times. According to statistics from Sun Binbin's team at Tianfeng Securities, in March 1988, the Federal Reserve chose to tighten monetary policy ahead of schedule to prevent a resurgence of high inflation. On March 30, 1988, the FOMC meeting raised the federal funds rate by 25 basis points to 6.75%, and subsequently raised rates 16 times, ultimately raising the target federal funds rate to 9.8125%, a total increase of 331.25 basis points.

The late 1980s were characterized by a resilient economy, a gradual accumulation of inflationary pressures that ultimately prompted the Federal Reserve to raise interest rates, followed by a slowdown in economic activity and a shift towards looser policy. The report also lists 1976-1977, 1996-1997, and 2013-2014 as other historical reference periods.

At the asset allocation level, the aforementioned macroeconomic background drove the model to further increase its holdings of risky assets and establish a distinct structural preference: going long on emerging markets and US stocks, going long on Japanese and UK duration, while maintaining the short position in US investment-grade credit bonds at the highest weight, going long on commodities with energy as the core, and shifting to a preference for the US dollar.

The austerity cycle of 1988-1989 has come back into focus.

A historical approximation analysis by Citigroup Research shows that the period from 1988 to 1989 became significantly more prominent this month. The report describes this period as characterized by a combination of economic resilience and inflationary pressures—a combination that prompted the Federal Reserve to continue tightening monetary policy in 1988 until it turned to cutting interest rates the following year after economic activity slowed.

This aligns closely with the current macroeconomic situation. The model shows that economic growth indicators are improving moderately, the average PMI z-score remains strong, and while the economic surprise index has slightly declined, its absolute level remains positive. Meanwhile, inflationary momentum has picked up somewhat in the past month, and financial conditions have tightened slightly, but overall remain approximately 0.55 standard deviations below their long-term average. The report characterizes the current macroeconomic situation as a symptom of "overheating"—both growth and inflation indicators are slightly above their long-term averages, but this has not yet triggered a model switch.

The report also retains three other historical reference periods: 1976-1977 (the pre-Volcker era, characterized by declining inflation and loose financial conditions, initially supporting the stock market, but subsequently leading to a sharp rise in inflation and policy rates); 1996-1997 (the early stages of internet expansion); and 2013-2014 (expectations of the Fed tapering its bond purchases drove a repricing of US interest rates). Notably, last year's tariff shock no longer constitutes a meaningful approximate historical reference in the latest model, which Citi Research believes reflects that long-term cross-asset volatility remains relatively low.

The model remains within the "normal" range, and the stock position is further increased.

In a recent article, Nick Timiraos, the “New Fed Watcher,” wrote that investors have largely accepted that the Federal Reserve will raise interest rates next week for the first time in three years; the more difficult question is what will happen afterward. Since the 1990s, the Fed has only had one “one-off” rate hike.

Despite rising market concerns about interest rate hikes, Citi Research's K-Nearest Neighbors (KNN) model remains in the "normal" range and has not shifted towards the "tightening financial conditions" range. The report notes that following this month's update, the model further increased its equity overweighting from 2.8% to 4.0%, maintained positive (but reduced) positions in bonds and commodities, and kept its short position in credit bonds unchanged.

The report also highlighted a potential downside path: if the energy shock continues as a persistent theme—whether driven by restocking demand or supply disruptions—tightening financial conditions and widening credit spreads could become the transmission chain leading to a stagflation scenario.

Regarding historical Sharpe ratio performance under different models, assets in the "normal" range perform similarly to the unconditional historical mean, with bonds showing a slight advantage, while US stocks have a certain advantage over other regions.

Across asset allocation: Energy leads the way, with the US dollar replacing the Japanese yen as the preferred currency.

In terms of specific asset allocation, Citi's research model exhibits a highly differentiated structure. On the equity side, emerging markets received the highest allocation, US equities maintained a slight bullish bias, while European, Japanese, and UK equities were shorted.

Regarding interest rates, bonds were overweighted by 3.7% overall, with Japanese and British bonds seeing the largest long positions, while US Treasuries were shorted to the maximum extent, and European bonds were shorted slightly. This allocation logic is partly related to the hawkish forward guidance following the ECB's rate hike and the rise in the risk premium of French government bonds.

In the commodities sector, energy is currently the strongest performing asset, with the model primarily overweighting energy, supplemented by a slight long position in base metals and a slight short position in precious metals. The report points out that energy's advantage in terms of relative carrying cost far exceeds that of other commodity subclasses, while the carrying of base metals and precious metals is significantly negative.

Regarding foreign exchange, the report points out that market enthusiasm for the yen has clearly waned, with the expected Sharpe ratios for the pound, yen, and euro against the dollar all negative, making the dollar the current preferred currency. This shift is partly due to US Treasury Secretary Bessant's comments on Japanese intervention and the weakening momentum of the yen's appreciation after a period of expectation that the Bank of Japan (BoJ) would tighten policy earlier and faster.

Trend-following strategies have maintained positive returns year-to-date, while systematic strategies have shown mixed performance.

From a quantitative strategy performance perspective, trend-following strategies recorded positive returns over the past month, with strong gains in commodities and bonds sufficient to offset losses in stocks and a roughly flat contribution from foreign exchange. Notably, bond trend-following strategies completely reversed their year-to-date losses this month, driving the overall strategy to positive returns. Commodities remain the largest contributor year-to-date, while stocks have been the weakest performer.

Carry strategies performed positively overall over the past month, with commodities and bonds contributing the main returns, while foreign exchange and equity carry trades came under pressure. The report also noted that commodity value strategies have continued to outperform year-to-date, but equity and bond value strategies remain negative, and bond value strategies have weakened further as the escalating situation in the Middle East forces market repricing inflation and policy risks.

In terms of CTA positioning, corporate bonds maintained the largest long position, while long positions in stocks and commodities were reduced to near neutral.

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