Does SOFR follow the FED - The Top 2 Factors Driving SOFR Changes

It’s a question that I get often, especially in our current rate environment. Does SOFR follow the Fed rate?

What I really think people are asking me, “Hey, the Fed lowered their rates, is SOFR lower too?”

It’s a worthy question from business owners and CFOs who are looking for the best financing solutions. The easy answer is “Yes, SOFR follows the Fed.” However, the reality isn’t a direct and immediate correlation.

What is SOFR

The Secured Overnight Financing Rate (SOFR) is a common benchmark used by banks to set pricing for various loan products. Think of the SOFR rate as the cost for banks to borrow money overnight, that is collateralized by U.S. Treasury securities.

SOFR is calculated every business day and posted at 8:00 AM EST by the New York Fed. The calculation for SOFR looks at the rate at which banks lend money to each other overnight for them individually to meet their 10% deposit reserve requirements. These transactions are called repurchase agreements, or “repos” for short (not to be confused with the repo that happens when you stop making your car payments). More specifically, SOFR is calculated by taking the volume-weighted median of transactions in three separate markets used for repurchase agreements. These three sources for the equation are:

1. Tri-party repo data
2. General Collateral Finance (GCF) repo data
3. Bilateral Treasury repos cleared through the Fixed Income Clearing Corporation’s Delivery vs. Payment Service.

How does the Fed Rate impact SOFR?

When the Federal Reserve meets to determine their monetary policy, they take a vote on what they want the Federal Funds Rate to be. To think about how this impacts SOFR, you need to keep in mind that the Fed is basically setting the "upper" and "lower" limits of SOFR.

The "lower" limit is the Fed Funds Rate. It doesn't make sense for a Bank to charge less interest for an overnight loan compared to the Fed Rate.

The "upper" limit really comes from the rate of the Discount Window. The Discount Window is a tool that banks can use as a last resort to meet their deposit requirements. This rate is set every 14 days by the Fed. Banks can borrow money from the Fed Discount Window at a higher rate compared to what is available from the open market of other bank participants.

Thus, SOFR will bounce around between these two rates. Below are three charts showing the trends for the three rates, dating back to December 19, 2019.

So, Does SOFR follow the FED?

As you can see, the answer is yes, but not right away.

Specifically, I'd draw your attention to the right edge of the three charts above. From what I can see, it looks like banks are more likely to bounce off the "upper" limit of the discount window in a falling rate environment, versus following in direct correlation with the drop in the Fed Funds Rate.

In our current economic environment, rates are expected to continue to fall over the next 12 months. With this, you can also expect to see the SOFR rate fall, but not in lock step with the Fed Funds Rate.

For business owners and CFOs focused on finding the best financing solutions, understanding these dynamics is essential. I encourage you all to do your research, stay aware of current monetary policy trends, and work with a knowledgeable banker. Keep an eye on all three of these rates as you make your financial decisions. Best of luck to you all in 2025.

Disclaimer - The opinions expressed within this article are those of the author Jacob Robertson and not that of any bank or organization Jacob is associated with. Nor does any bank or association endorse these opinions.