As SOFR Eases, Funds Rate Refuses to Follow

Executive Summary

The effective federal funds rate (EFFR) remains pinned at 3.64%, even as SOFR pressures have eased and the Federal Reserve has injected liquidity through T-bill purchases. The rate’s proximity to the interest on reserves level underscores continued tightness in short-term funding markets, driven by repo dynamics, structural constraints, and limited balance sheet flexibility. A pending leverage ratio change could ease pressures, with implications for Treasury yields and curve direction.

Funds Rate Pinned at the Top

The Federal Reserve’s balance sheet expansion has yet to deliver the intended easing in funding markets, with the effective federal funds rate stubbornly holding at 3.64%—just 1 basis point below the interest on reserves rate.

That persistence at the top of the Fed’s 25bp target corridor raises broader questions about whether the system is truly operating with “ample reserves,” or instead hovering closer to a scarcity threshold.

The EFFR historically traded comfortably within the policy band, typically around 8 basis points above the lower bound. That spread widened to roughly 14 basis points in late 2025 as reserves dipped below $3 trillion, triggering recurring bouts of repo tightness.

Even after reserves have climbed back above that level, the funds rate has refused to move lower. With the spread to IOER now just 1 basis point, arbitrage dynamics effectively cap any further increase, leaving the rate pinned near the ceiling but unable to ease meaningfully.

Repo Driving Relative Value Pressure

At the center of the dynamic is the relationship between fed funds and repo markets. SOFR, which reflects secured overnight borrowing costs, should theoretically trade below fed funds. In practice, that relationship has become unstable.

During periods of repo tightness, SOFR can approach or exceed the EFFR, incentivizing relative-value trades that pull the funds rate higher. These flows are shaped by a fragmented system in which different participants operate across reserves, reverse repo, and market repo channels—each competing for balance sheet capacity.

Federal Home Loan Banks play a pivotal role as marginal lenders in the fed funds market. Unable to earn interest on reserves, they deploy liquidity into fed funds, while commercial banks often prefer to hold reserves at IOER.

This structural imbalance effectively anchors the funds rate near the upper bound of the corridor, reinforcing its current stickiness.

Balance Sheet Expansion Falls Short

Since mid-December 2025, the Fed has purchased roughly $200 billion in Treasury bills, lifting reserves by approximately $180 billion to just over $3 trillion. Total holdings have risen to about $6.3 trillion.

Despite this expansion, the EFFR has not declined, suggesting that liquidity conditions remain tighter than headline reserve levels imply. The system appears sensitive to reserve thresholds, where even modest declines can trigger disproportionate stress in repo markets.

The persistence of elevated funding costs has revived debate about whether the Fed is drifting away from its ample reserves framework. Lessons from the 2019 repo episode remain instructive: as reserves fell, repo rates spiked, forcing the Fed to intervene with T-bill purchases—an approach effectively repeated in late 2025.

A key inflection point may be the April 1, 2026 revision to leverage ratio requirements, which will now allow large banks to hold more Treasuries and intermediate repo flows. Greater balance sheet flexibility could enable banks to step in during repo dislocations, dampening SOFR volatility and relieving upward pressure on the EFFR.

Front-End Resistance

For Treasury investors, the implications are clear: elevated overnight funding costs act as a floor under front-end yields. Even as markets price in additional Fed cuts, bill and short-dated Treasury yields may struggle to decline meaningfully.

If the leverage rule change successfully loosens repo conditions, it could catalyze a downward move in the EFFR and support a steeper yield curve. Until then, the stickiness of funding rates suggests that front-end easing will remain constrained, with longer maturities more responsive to macroeconomic shifts.

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