Will the Fed "continue raising interest rates"? Will the "tightening cycle" of the late 1980s be repeated?

Market concerns over the Federal Reserve resuming rate hikes are intensifying, bringing a notably cautionary period in history back into investors' focus. According to Citi Research's latest quantitative macro strategy report, the current macro environment bears a striking resemblance to the 1988-1989 tightening cycle. At the same time, renewed tensions in the Middle East and resurging inflation pressures in the US are quietly altering the logic of cross-asset allocation.

According to Chasing Wind Trading Desk, Citi Research analysts Alex Saunders and Vinh Vo pointed out in their September 11 report that although their macro model (Regime Model) overall remains in the “Normal” zone, strengthening inflation momentum, a mild decline in the economic surprise index, and a slight tightening of financial conditions are causing the historically similar period identified by the model to converge on 1988-1989.

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 Tianfeng Securities’ Sun Binbin team, in March 1988, the Fed chose to tighten proactively to prevent a return to high inflation. On March 30, 1988, the FOMC raised the federal funds rate by 25bp to 6.75%. Thereafter, there were 16 rate hikes in total, with the target federal funds rate eventually increasing to 9.8125%, for a total rate hike of 331.25bp.

The late 1980s were characterized by resilient economic activity and gradually accumulating inflationary pressures, which led the Fed to persistently hike rates until economic activity slowed and policy subsequently turned accommodative. The report also lists 1976-1977, 1996-1997, and 2013-2014 as other historical reference periods.

On the asset allocation front, the above macro backdrop is driving the model to further overweight risk assets with a distinct structural bias: going long on emerging markets and US equities, long duration in Japan and the UK, maintaining a maximum overweight short in US investment-grade credit, going long commodities with energy as the core, and shifting preference toward the US dollar.

Citi Research’s historical analog analysis also indicates that the prominence of the 1988-1989 period increased significantly this month. The report describes an environment in which economic resilience coexists with inflationary pressure—this very combination drove the Fed to keep tightening monetary policy in 1988 until economic activity slowed down the following year, prompting a turn to rate cuts.

This scenario closely matches the current macro state. The model shows moderate improvements in economic growth indicators, the average PMI z-score remains robust, and though the economic surprise index has retreated slightly, its absolute level is still positive. At the same time, inflation momentum has picked up over the past month, with financial conditions tightening slightly but remaining about 0.55 standard deviations below the long-term average. The report characterizes the current macro state as symptomatic of an “overheating economy”—both growth and inflation readings are slightly above the long-term average, but not enough to trigger a model regime switch yet.

The report also retains three other historical reference periods: 1976-1977 (pre-Volcker era, when falling inflation and easy financial conditions initially supported equities, but subsequent sharp rises in inflation and policy rates followed); 1996-1997 (early Internet expansion); and 2013-2014 (when the Fed’s QE tapering expectations repriced US rates). Notably, last year’s tariff shock no longer serves as a meaningful historical analog in the latest model, which Citi Research interprets as evidence that cross-asset volatility remains relatively low for the long term.

Despite heightened worries about rate hikes, Citi Research’s K-nearest neighbors (KNN) model remains in the “Normal” zone, not switching to the “Tightened Financial Conditions” regime. The report highlights that this month, the model raised the equity overweight from 2.8% to 4.0%, maintaining a positive allocation to both bonds and commodities (with some trimming), while the short position in credit remains unchanged.

The report also flags downside risks: if the energy shock persists—whether driven by inventory restocking or supply flow interruptions—a tightening of financial conditions and widening credit spreads could pave the way toward a stagflation scenario.

In terms of historic Sharpe ratios under different model regimes, performance in the “Normal” regime approximates the unconditional historical mean, with bonds slightly outperforming, and US equities enjoying a relative advantage over other regions.

Regarding specific portfolio allocations, the Citi Research model exhibits a highly differentiated structure. For equities, emerging markets receive the highest allocation, US equities are held at a slight net long, while European, Japanese, and UK equities are shorted.

For interest rates, bonds have an overall overweight of 3.7%, with maximum long in Japanese and UK duration, maximum short in US Treasuries, and a slight short in European bonds. This allocation is partly linked to the ECB’s hawkish forward guidance post-hike and a rise in French sovereign risk premiums.

In commodities, energy is currently the strongest expected performer, with the model concentrated in energy overweights, minor longs in base metals, and slight shorts in precious metals. The report notes that energy exhibits far superior relative carry compared to other commodity sub-sectors, while carry in base and precious metals is notably negative.

In FX, the report points out that market enthusiasm for the yen has clearly faded. Expected Sharpe ratios for GBP, JPY, and EUR versus the USD are all negative, establishing the dollar as the preferred currency. This shift is partially attributed to US Treasury Secretary Yellen’s comments on Japan’s intervention, as well as waning momentum in the yen after expectations that the Bank of Japan (BoJ) would tighten policy earlier or more swiftly propelled it higher.

In terms of quantitative strategy performance, trend-following strategies posted positive returns over the past month, with strong gains in commodities and bonds more than offsetting losses in equities and a nearly flat contribution from FX. Notably, trend-following in bonds fully reversed its prior year-to-date losses this month, driving the overall strategy back into positive territory. Commodities remain the largest contributor YTD, while equities lag the most.

Carry strategies delivered positive overall results in the past month, with commodities and bonds providing the main returns, while FX and equity carry were under pressure. The report also notes that commodity value strategies continue to lead YTD, but equity and bond value strategies remain negative, with bond value underperforming further as escalating Middle East tensions prompt markets to reprice inflation and policy risks.

For CTA positioning, credit remains the largest long; equity and commodity longs have been cut back to near-neutral.