The most important price in the world

Is it the price of gold? The price of oil? The price people have to pay for water?

These are all important prices. But none of them matter as much as one key price the price of money.

That might sound odd. So let me put it another way the price of money is the interest rate.

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That's all interest rates are at heart. They set the price at which money can be borrowed. And these prices are so critical, because they have a knock-on impact on every area of investment and the economy.

The key interest rates

There are many different types of interest rate, all of which are important in the financial world.

Most of us think wehave a rough idea of the interest rate we are getting on our savings. We probably have a very good idea of what rate we are paying on our mortgage. And every month the media will report whether the Bank of England base rate has gone up or not.

But how are these interest rates set? And which ones are most important? Below we'll take a look at some key rates.

The Bank of England base rate

Every month a group of individuals known as the Monetary Policy Committee (MPC) get together to set the Bank of England base rate.

In essence, this is the rate of interest that the Bank will charge to lend to other banks and building societies. In turn, this rate will then have an impact on the rates that they can offer on their savings accounts or charge on their loans and mortgages.

The MPC uses interest rates to try to control the economy. When interest rates are low in other words, the price of money is cheap it becomes easier to borrow. When people borrow and spend more, that increases the amount of money flying around the economy.

If there's a lot more money than there is goods and staff to spend it on, then there's a danger that price increases (inflation) will spiral out of control. In this case, the MPC might raise interest rates. This makes money more expensive to borrow, which could encourage people to save more and borrow and spend less.

At the moment, the MPC wants people to spend rather than save and is keeping interest rates low to try and help the economy grow.

The stock market will often rise if an interest rate cut is expected, as investors usually believe that cheaper money will help both the economy and company profits to grow.

The government bond market

The Bank of England rate is important. But arguably the most important interest rates out there are the ones that governments have to pay to borrow.

In an ideal world, a government wouldn't spend more than it takes in taxes each year. Or it would at least get the budget to balance over time. Unfortunately governments (in the West certainly) have a habit of persistently spending more than they earn'.

They have to get the money from somewhere. That place is the bond market. This is where the government goes to borrow money from investors people like you and me, huge institutions, other governments you name it.

The interest rate that lenders charge a government depend on lots of things. But by and large, it comes down to how creditworthy a government is (what's its track record of payment?); how healthy the economy is (if an economy isn't growing, how's it going to pay back the loan?); and what the rate of inflation is like (if the interest rate on a bond is below the rate of inflation, the lender is losing money in real terms).

If many investors want to buy government bonds (in other words, lend money to a given government) then the government's cost of borrowing will fall. In other words, it won't have to pay as much interest on the loan. If few investors are willing to lend, the cost of borrowing will rise.

Interest rates on bonds are expressed in terms of yields. These can be simple income yields (bond interest, or coupon/bond price). Or you can look at redemption yields which tell you your annual return if you hold a bond until it is paid back (yield to maturity).

For example, take Germany. Its government roughly spends what it takes in each year, has low inflation, and a healthy economy. So it can borrow money for ten years at a rock-bottom rate of 1.3%. On the other hand, Greece, which is effectively bust, would have to pay 17.7%.

If investors think that governments will spend too much money or that inflation will rise (reducing the real value of their bonds and interest payments), then they will sell its bonds. This will cause their price to fall and interest rates to rise. All else being equal, healthier government finances and lower inflation will see more buyers, higher bond prices and lower interest rates.

Corporate bond markets

Academics have long argued that government bonds are supposed to be one of the safest assets out there. This is because governments go bust relatively rarely (certainly in the developed world). They can also usually print their own money to pay investors back if needs be. This isn't necessarily a good thing, as it may spark inflation. But it does mean that the UK or US for example, need never default on their bonds, although they may end up repaying them in a far weaker currency.

Companies on the other hand, can and do go bust. The interest rates on corporate bonds (the debt of companies listed on the stock exchange) should therefore reflect this higher risk, say the academics. In other words, they should have to pay more to borrow money than most governments.

That said however, big, multinational companies such as Johnson & Johnson can borrow almost as cheaply as the US government. This is because they sell products that are always in demand, and also have impeccable finances. For example, the US government can currently borrow for ten years at 1.65%, whereas Johnson & Johnson can borrow for the same period of time at 2%.

As businesses become more risky and they take on more debt, it makes sense that they have to pay more to borrow money.

For example, UK pub company Enterprise Inns has lots of debt and struggles to make enough money to comfortably pay the interest on this debt. Its bonds, which have to be paid back in 2018, currently yield 8.6%. The UK government bond (gilt) which has to be paid back in the same year yields only 0.9%.

The interest rate' on shares

shares can be said to have interest rates' as well, if you want to put it that way. The most common ones are the dividend yield (dividend per share/share price) and the earnings yield (earnings per share/share price).

Shareholders are the last people to get paid by companies. All the company's bills, including the interest charged on its borrowings, and its tax bill, must be paid before shareholders get a penny.

This makes shares more risky than either corporate or government bonds. Because of this, it could be argued that the dividend and earnings yields on shares should be higher in order to reflect this added risk.

The FTSE-All Share Index currently trades on a prince/earnings (p/e) ratio of 11.7 times, giving it an earnings yield of 8.5% (the earnings yield is 1/pe so 1/11.7 = 8.5%). The dividend yield of the index is 3.7%, compared to the iBoxx corporate bond index which yields 3.4%.

So why do interest rates matter so much?

Interest rates determine what people, governments and companies pay for money. As a result, they also determine the price of most financial assets, including shares, bonds and property.

How does this work? Well, think about assets in terms of their riskiness, as we outlined above.

You can argue over just how low-risk government bonds are, but for sake of argument let's accept that they are among the lowest-risk assets.

Because there's not much risk that you won't get paid back, your expected return should reflect this. In other words, the interest rate on government bonds in the developed world should be low, relative to all other financial assets.

This means that if the interest rate on government bonds rises, then it should rise on other assets too, because these are riskier than government bonds.

But how does this happen in practice?

Well, let's say investors get worried about the state of the UK government's finances. They no longer want 2% interest to lend it money for ten years. Instead, they now want 4%.

The interest rates on other assets may go up by 2% as well in order to reflect this added risk. So the yield on corporate bonds might go up to 5.7% and the earnings yield on shares might go up to 10.5%.

But companies don't increase their payouts. What happens instead is that the prices of bonds and shares tend to fall, which pushes up yields.

What happens when rates fall?

The reverse happens when interest rates fall. One of the major reasons for the bull market in shares from the early 1980s to 2000, was that interest rates on government bonds fell rapidly from 15.8% to less than 5%. The bond bull market has gone on even longer with yields in many developed markets now below 2%.

This made other assets (shares and property) with higher yields look cheap, so investors paid more for them and brought their interest rates down in turn.

The relationship between interest rates and asset prices, can also explain why share prices even if profits are growing can go nowhere for years if interest rates are rising, as they were between the mid-1960s and early 1980s. The rise in profits is not enough to offset the rise in interest rates.

So, while it's vital to look at fundamental' factors such as profits when pondering an investment, you should have a think about big picture' concerns, such as where interest rates are as well. It could make the difference between making a decent profit, or a big loss.