'A steeper yield curve is likely, but not for the usual reasons'

The yield curve, the gradation from overnight money to long dated, is very steep, often taken to be a portent of rising inflation

Doing some simple sums on ordinary and index-linked gilts gives us an indication of the future inflation rates implied by current markets. What the sums do not tell us is whether this is what markets actually mean or whether this is just some serendipitous outcome of other dynamics.

This is the sort of stuff economists love to chunter over by the coffee machine (there really is no end to the excitement). These days, though, it's not just economists that should be boning up on yield curves – and currencies – and watching them closely.

The Bank of England's quantitative easing (QE) programme has sucked in huge amounts of gilt stock and depressed yields. QE will not last forever and the Bank's absence as the biggest buyer in town must alter the supply/demand dynamics adversely. If this coincides with some initial normalisation of the base rate, the yield curve need not steepen, it just sits higher than it was.

But with the public finances in a far worse mess than anyone is willing to admit, fiscal policy will be tightening even if recovery is still weak. The Bank may judge that its monetary policy should remain stimulative and keep the base rate low. Then the curve would steepen even more. Ordinarily a steep yield curve is a free ride – a true windfall – for the banks, coining the margin between short-term financing and longer-term lending, but what we learnt from 2008 is that too much of a good thing is disadvantageous when wheels start coming off. So banks' cost of capital post crisis is much more exposed to the rising yield curve than usual. The curve itself may continue to frustrate monetary policy, keeping the actual cost of borrowing high even while policy rates are low.

The incentive might then be for the Bank to extend QE even further. This is possible but with the Treasury issuing huge volumes of gilts to plug the financing gap, the Bank buying them under QE and the Treasury indemnifying the Bank against any losses, there is a circularity that can go only so far.

So a steeper yield curve is likely, but not for the usual reasons. Instead of portending an overheating economy and anticipated inflation it will be a further headwind for an already struggling economy. This is not good.

But it could be worse. Everyone's assumptions for the future, even those as pessimistic as mine, assume that the government's borrowing requirements can be funded, that the markets will absorb all the new stock at yields that are not cripplingly high. Usually this is a safe bet but today it isn't. When a borrower is in trouble, lenders need the reassurance of a credible recovery plan. On the strength of the mini-budget the UK does not have one, offering instead only pious and unquantified statements of intent. We risk pushing our lenders over the edge.

The UK is not (yet) Greece or Ireland but it is not as far removed as it likes to think. If the current outlook is uncomfortable, try a buyers' strike in the gilts market and a collapse in sterling. I remember one of those; we needed the IMF to bail us out. Looking to Ireland we should surely tremble at what the markets might do to us if we push our luck. Think I'm making this up just to ruin the festivities? Think again: look at what gilt yields and sterling have done since that hollow non-event of a Pre-Budget Report. Retribution for a decade's profligacy could be on its way already.

Peter Bickley is director of economics at Deutsche Bank Private Wealth Management.