Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Secured Overnight Financing Rate
Transcript
- Lucas: So, the secured overnight financing rate — SOFR — hit its quarter-end spike in late June, settling at five-point-three-eight percent. That was about seventeen basis points above the fed funds rate that same day. Luna: Right, that spread is the interesting bit. Because SOFR is supposed to be a risk-free rate, but it regularly jumps when banks and dealers pull back balance sheet at quarter-end. Lucas: Exactly. And that tells us something about the plumbing underneath all those interest rate benchmarks we talk about. SOFR is now the dominant reference rate for over sixteen trillion dollars in derivatives and loans globally, having replaced LIBOR a few years back. Luna: It really is the new bedrock. But I think a lot of listeners still don't know how it's actually constructed. I mean, what makes it 'secured' and what makes it 'overnight'? Lucas: Sure. SOFR measures the cost of borrowing cash overnight, backed by Treasury collateral — that's the 'secured' part. Every morning, the New York Fed collects transaction data from the tri-party repo market, the GCF repo market, and bilateral repurchase agreements. They take a volume-weighted median of the rates on those trades, and that becomes the published SOFR. Luna: So it's not a survey like LIBOR was. It's actual observable transactions. That's a huge difference. Lucas: Huge. LIBOR was partly estimated, because banks weren't always borrowing unsecured in size every day. SOFR is based on roughly a trillion dollars of daily trading volume in the repo market. You can't game that. Luna: And that's why central banks love it. The Federal Reserve, the Bank of England, the ECB — they all pushed for a transition to transaction-based benchmarks after the LIBOR manipulation scandals. It makes the whole system more transparent. Lucas: Before we go deeper — and I know I say this sometimes, but this show stays ad-free because of listeners like you who chip in to keep it that way. If walking through the economy with us has made something click for you, you can support us at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep this going without any sponsor noise. Appreciate everyone who's already done it. Lucas: All right, back to SOFR. The thing is, because SOFR is collateralised, it's almost always lower than the fed funds rate — except at month-end and quarter-end, when it spikes. Luna: Because banks don't want to lend against Treasury collateral on the last day of the quarter, since it uses up balance sheet. So the rate jumps. Lucas: Right. And those spikes are a signal to central banks. A very large spike — say, fifty basis points or more — suggests that collateral is becoming scarce, or that banks are unusually constrained. The Fed's standing repo facility is meant to cap that, but if the cap itself is too high, it doesn't really help. Luna: It's almost like a stress indicator. If SOFR stays elevated for a few days after quarter-end, that's even more worrying. Lucas: Precisely. And this June, the spread over fed funds was about seventeen basis points — notable but not alarming. Back in September 2019, SOFR spiked to over five percent when the repo market seized up, and the Fed had to intervene with emergency repo operations. Luna: So SOFR is not just a benchmark for contracts; it's a real-time window into funding markets. Central banks watch it daily. Lucas: They do. And they also care about the volume-weighted nature of the rate. SOFR can be influenced by which trades happen at what time. The New York Fed publishes it at eight a.m. Eastern, but trades executed later in the day might carry different rates. That's why there's also a 'SOFR Averages' and 'SOFR Index' for longer-term contracts. Luna: How does that affect borrowers with floating-rate loans tied to SOFR? Say someone has a mortgage that adjusts every year based on the twelve-month average SOFR. Lucas: It smooths out the quarter-end spikes. The average is computed over the term, so those one-day jumps barely move the needle. In fact, the International Swaps and Derivatives Association — ISDA — standardised how SOFR is compounded in arrears for derivatives, so that spike days are diluted. Luna: That makes sense. But there's also the question of the SOFR rate versus the fed funds rate as a policy tool. The Fed controls the fed funds rate through the interest on reserves and the overnight reverse repo facility. SOFR is market-driven within that corridor. Lucas: Exactly. SOFR usually trades within the fed funds range, but it can dip below the floor if demand for Treasuries is extraordinarily high, like during flight to safety episodes. And it can spike above the ceiling if liquidity dries up. That's when the Fed's standing repo facility kicks in. Luna: Right, because the standing repo facility offers cash to primary dealers at a fixed rate, which should put a lid on SOFR. But the rate was set at twenty-five basis points above the general collateral repo rate, if I remember correctly. Lucas: Yes. And the Fed adjusts that spread periodically. The Standing Repo Facility rate is now twenty-five basis points above the IORB rate — the interest on reserve balances. So if SOFR threatens to run above that, dealers can borrow from the Fed instead, capping the spike. Luna: But we still saw seventeen basis points above fed funds in June. So the cap isn't always hit. Maybe the market works fine most of the time. Lucas: That's the thing. In normal times, the private market clears efficiently. But if there's a sudden collateral shortage — say because Treasury issuance surges and dealers are forced to hold inventory — SOFR can jump significantly before it reaches the standing repo rate. Luna: And that's why the Fed publishes SOFR daily. For transparency. But also so they can fine-tune their facilities. If SOFR consistently sits near the top of the corridor, it's a hint that the corridor might be too wide. Lucas: Exactly. One more nuance — SOFR also matters for the Fed's thinking on the neutral rate of interest, or r-star. If SOFR is persistently high relative to policy expectations, it might signal that the natural rate is higher than assumed. But that's a very indirect signal. Luna: And it's complicated by the fact that SOFR is a secured rate. The neutral rate is about the economy's real rate of return, not just overnight repo. Lucas: Right. So central banks layer it with other data. But SOFR is a key piece of the puzzle. And as the transition from LIBOR completes, more and more everyday loans are referencing it. The Consumer Financial Protection Bureau has even issued guidance on adjustable-rate mortgages tied to SOFR. Luna: So the plumbing matters to Main Street too. If SOFR spikes, it can affect the cost of an ARM for a homeowner, even if the Fed hasn't changed rates. Lucas: Yes, but again, because most consumer loans use an average, the effect is muted. The bigger risk is in the derivatives market, where a sudden repricing could cause margin calls. That's why the Fed and the international regulators require clearing houses to stress-test against a SOFR spike. Luna: Interesting. So SOFR is kind of a canary in the coal mine for funding stress. Central banks watch it not just as a benchmark but as a vital sign. Lucas: Exactly. And that's why I wanted to dedicate an episode to it. Most people only hear about SOFR when it spikes, but understanding how it's constructed and what drives it helps you interpret those spikes. Is it a blip, or is something structural changing? Luna: And we're in a period where Treasury issuance is high, the Fed is running quantitative tightening, and bank reserves are declining. All of that could make SOFR more volatile. Lucas: Yes. The Fed's own research has shown that as reserves decline, the volatility of overnight rates increases. SOFR becomes more sensitive to small imbalances between cash and collateral. So we should expect more frequent quarter-end spikes. Luna: So if I'm a bond trader or a corporate treasurer, I need to watch SOFR closely, especially around month-end and quarter-end. Lucas: Absolutely. And maybe even hedge against that volatility. There are futures and options on SOFR that allow you to lock in rates for future periods, similar to the old Eurodollar futures. Luna: Right. And those are some of the most heavily traded contracts in the world now. The CME Group's SOFR futures volume surpassed Eurodollar futures a couple of years ago. Lucas: Exactly. So SOFR is everywhere. And yet, there's a lingering concern: because it's a secured rate backed by Treasuries, it can behave differently from unsecured lending rates like the fed funds rate or bank funding costs. Some economists argue that we still need a measure of unsecured bank credit risk. Luna: That's why the Fed publishes the Bank Funding Rate — a composite of unsecured funding costs. But it doesn't have the same depth of transactions as SOFR. Lucas: Right. So SOFR is the workhorse, but not the whole picture. Central banks cross-reference it with other rates. And that leads us back to the original question: what does the June quarter-end spike tell us? Not much by itself. But if next quarter we see a thirty-basis-point spike, then we have a trend. Luna: And the Fed will be watching. Maybe they'll adjust the standing repo facility rate, or tweak the spread. But for now, SOFR is telling them the market is functioning, albeit with some end of period friction. Lucas: Exactly the right takeaway. And as always, if this clarified something for you, consider supporting the show at buy me a coffee dot com slash fexingo. We'll be back next time with another deep dive into the tools central banks use.