Let's take a high level look at the relationship between central bank rates and the new risk-free rates or RFRs. As you can see on the chart, RFRs tend to remain relatively stable for extended periods, but occasionally show sharp increases or decreases.

These significant movements often coincide with central bank decisions to raise or lower their benchmark interest rates.

So there is a strong, though not perfect link between central bank rates and RFRs, and it operates roughly as follows. Central bank rates generally represent the rates that central banks charge commercial banks for overnight loans, and these are set directly by the central bank. For example, when a central bank decides to raise its benchmark rates, it makes borrowing money more expensive for banks.

Banks in turn often pass on these higher costs to their clients, resulting in more expensive loans such as mortgages or business loans. A real world example of this relationship is the US Federal Reserve's rapid rate hikes seen during 2022 facing rising inflation. The Fed raised its benchmark federal funds rate multiple times over the course of the year.

As a result, the SOFR secured overnight financing rates, which is directly tied to the cost of overnight borrowing in the repo market increased sharply. This in turn, led to higher borrowing costs across various financial markets, demonstrating the strong link between central bank policy and RFRs. So central bank rates are typically for overnight loans, which is why there is a clear correlation with risk-free rates, or RFRs, which are also overnight rates.

But how does central bank rates influence longer term rates? The key lies in expectations. Longer term rates are often seen as the expected average of future short-term or overnight rates over the relevant term.

For example, a one month term rates can be viewed as the expected average of individual overnight rates over the next month. When a central bank raises its overnight rates, it directly affects short term borrow costs. However, if market participants expect the central bank to keep raising rates in the future, they will also expect higher short-term rates over time.

As a result, longer term rates such as those for loans or bonds with maturities of one month, three month, or longer, Will adjust upward to reflect those future expectations of higher short-term rates. This dynamic explains why central banks, by changing the current overnight rate and influencing expectations of future rate movements, can have a significant impact, not just on short term borrowing costs, but also on longer term interest rates.