SOFR vs Fed Funds Rate

SOFR and Federal Funds Rate are connected through the Treasury yield curve and monetary policy expectations. When the policy rate path shifts, both respond, though with different sensitivities and at different speeds. The spread between SOFR and Federal Funds Rate captures the specific macro signal that flows through this relationship.

SOFR tends to lead Federal Funds Rate during policy regime shifts, where the short end moves before the long end reprices. In those periods, moves in SOFR precede corresponding moves in Federal Funds Rate by days to weeks, depending on the transmission channel and the depth of each market.

Long-run correlation between SOFR and Federal Funds Rate varies by regime. Yields at different maturities are typically positively correlated in direction but differ in magnitude, which is what makes the spread informative. The correlation is not stable: it shifts with macro conditions, and the periods when it breaks down are often the most informative moments in the SOFR-Federal Funds Rate relationship.

Divergence between SOFR and Federal Funds Rate typically arises from quantitative easing, quantitative tightening, foreign reserve flows, or term premium dislocations. When one asset's idiosyncratic drivers dominate, the spread moves in ways that the common macro story does not predict, which is usually a signal to look more carefully at the specific drivers at work in SOFR or Federal Funds Rate.

Within the Treasury curve, SOFR is not typically a hedge for Federal Funds Rate; they are both duration exposures with different convexity and roll characteristics. Effective hedging requires matching the hedge to the specific risk being protected, and the SOFR-Federal Funds Rate pair is best stress-tested under scenarios the investor most worries about before being sized into a real portfolio.