Will the Federal Reserve 'Raise Rates Continuously'? Will the 'Tightening Cycle' of the Late 1980s Recur?

Original Title: "Will the Federal Reserve 'Raise Rates Continuously'? Will the 'Tightening Cycle' of the Late 1980s Recur?"
Source: Wall Street Insight

Citigroup's report points out that the current macro environment is highly similar to the tightening cycle of 1988-1989, when the economy remained resilient, inflationary pressures gradually accumulated, and only after economic activity slowed did policy shift to easing. During that tightening cycle, the Federal Reserve raised rates 16 times in a row. Concerns about the Federal Reserve restarting rate hikes are rising, bringing a historically cautionary cycle back into investors' view. Citigroup's latest quantitative macro strategy report shows that the similarity of the current macro environment to the tightening cycle of 1988 to 1989 has significantly increased, compounded by the renewed escalation of the Middle East situation and the resurgence of inflationary pressures in the U.S., leading to a quiet change in cross-asset allocation logic.

According to reports from the Wind Trading Desk, Citigroup research analysts Alex Saunders and Vinh Vo pointed out in a report released on September 11 that although their macro model (Regime Model) remains in the 'Normal' range overall, the momentum of inflation is strengthening, the economic surprise index is gently declining, and financial conditions are slightly tightening, causing the historically similar periods identified by the model to converge towards 1988 to 1989.

Notably, during the tightening cycle from March 1988 to May/June 1989, the Federal Reserve raised rates a total of 16 times. According to statistics from the Sun Binbin team at Tianfeng Securities, in March 1988, the Federal Reserve chose to tighten in advance to prevent a return to 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 a total of 16 times, ultimately increasing the federal funds rate target to 9.8125%, a total increase of 331.25 basis points.

The typical characteristics of the late 1980s were that the economy maintained resilience, inflationary pressures gradually accumulated, ultimately prompting the Federal Reserve to continue raising rates, and only after economic activity slowed did policy shift to easing. The report also lists 1976 to 1977, 1996 to 1997, and 2013 to 2014 as other reference historical periods.

In terms of asset allocation, the aforementioned macro background drives the model to further increase holdings in risk assets and establish a clear structural preference: going long on emerging markets and U.S. stocks, going long on Japanese and UK durations, while maintaining the maximum weight of short positions in U.S. investment-grade credit bonds, focusing on energy to go long on commodities, and shifting preference towards the U.S. dollar.

The Tightening Cycle of 1988 to 1989 Returns to View

Nick Timiraos from the 'New Federal Reserve News Agency' recently wrote that investors have basically concluded that the Federal Reserve will raise rates for the first time in three years next week, but the more difficult question is what will happen afterward. Since the 1990s, the Federal Reserve has only had one instance of a 'one-off' rate hike.

Citigroup's historical similarity analysis also shows that the period from 1988 to 1989 has become more prominent this month. The report describes this period as a combination of economic resilience and inflationary pressures—this combination prompted the Federal Reserve to continue tightening monetary policy in 1988 until economic activity slowed the following year, at which point it shifted to rate cuts.

This aligns closely with the current macro state. The model shows that economic growth indicators are improving moderately, the average PMI z-score remains at a strong level, the economic surprise index has slightly declined but remains positive; meanwhile, inflation momentum has rebounded over the past month, and financial conditions have slightly tightened, remaining about 0.55 standard deviations below the long-term mean. The report characterizes the current macro state as symptoms of 'economic overheating'—both growth and inflation indicators are slightly above the long-term mean but have not yet triggered a model switch.

The report also retains three other historical reference periods: 1976 to 1977 (pre-Volcker era, where inflation was declining and financial conditions were easing, initially supporting the stock market but later leading to a significant rise in inflation and policy rates); 1996 to 1997 (early internet expansion); and 2013 to 2014 (the Federal Reserve's tapering expectations driving the repricing of U.S. rates). Notably, the tariff shocks from last year no longer constitute a meaningful historical reference in the latest model, reflecting that cross-asset long-term volatility remains relatively low.

The Model Stays in the 'Normal' Range, Stock Positions Further Increased

Despite rising concerns about rate hikes, Citigroup'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 ratio from 2.8% to 4.0%, while maintaining positive allocations in bonds and commodities (though slightly reduced), and keeping credit bond short positions unchanged.

The report also highlights potential downside paths: if energy shocks continue as a persistent theme—whether driven by replenishment demand or supply disruptions—tightening financial conditions and widening credit spreads may become the transmission chain leading to a stagflation scenario.

In terms of historical Sharpe ratio performance under different models, the asset performance in the 'Normal' range is similar to the unconditional historical mean, with bonds slightly outperforming, while U.S. stocks have a relative advantage over other regions.

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

In specific asset allocation, Citigroup's research model shows a highly differentiated structure. In terms of stocks, emerging markets receive the highest allocation, U.S. stocks maintain a slight long position, while European, Japanese, and UK stocks are shorted.

In terms of interest rates, bonds are overall overweight by 3.7%, with the largest long positions in Japanese and UK durations, while U.S. Treasuries are maximally shorted, and European bonds are slightly shorted. This allocation logic is partly related to the hawkish forward guidance from the European Central Bank after rate hikes and the rising risk premium on French government bonds.

In terms of commodities, energy is currently the asset with the strongest expected performance, with the model focusing on 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 holding costs (carry) far exceeds that of other commodity subclasses, while the carry for base metals and precious metals is significantly negative.

In terms of foreign exchange, the report notes that market enthusiasm for the yen has clearly faded, with the expected Sharpe ratios for the pound, yen, and euro against the dollar all being negative, making the dollar the current preferred currency. This shift partly stems from U.S. Treasury Secretary Janet Yellen's statements on Japan's intervention issues and market expectations for the Bank of Japan (BoJ) to tighten policy earlier and faster, which have weakened the momentum of the yen's phase of appreciation.

Trend Following Strategies Maintain Positive Returns Year-to-Date, Systematic Strategy Performance Diverges

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 stock losses and yield a roughly flat contribution from foreign exchange. Notably, the bond trend-following strategy completely reversed its previously negative year-to-date returns this month, pushing the overall composite strategy into positive territory. Commodities remain the largest source of contribution year-to-date, while stocks performed the weakest.

The carry strategy's overall performance over the past month has been positive, with commodities and bonds contributing the main gains, while foreign exchange and stock carry faced pressure. The report also notes that the commodity value strategy has continued to lead year-to-date, but stock and bond value strategies remain in negative territory, and as the situation in the Middle East escalates again, prompting the market to reprice inflation and policy risks, the bond value strategy has further weakened.

In terms of CTA positioning, credit bonds maintain the largest long position, while long positions in stocks and commodities have been reduced to near neutral.

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