Bernanke and Draghi's market bondage

Financial markets experienced a fleeting bout of optimism overnight, as investors reassured themselves that the outlook has become so bleak that global central banks will be forced into providing some relief.

In the United States, Ben Bernanke, the boss of the US central bank, is clearly dissatisfied with the sluggish economy, and disappointingly high unemployment levels. Although he's so far resisted introducing a new round of quantitative easing – buying huge amounts of US government bonds and mortgage-backed securities using newly printed money – he now appears close to relenting.

As a result, investors are hoping that the US central bank will unveil a third round of quantitative easing – dubbed QE3 – as early as next week, and are already pushing share markets higher in anticipation.

Investors are eagerly awaiting QE3 because when the US central bank buys huge quantities of bonds, it injects a massive amount of liquidity into markets. This pushes US and global stock markets higher. This is clearly good news for the wealthy, who tend to own large share portfolios. When the US central bank undertook QE1 and QE2, Bernanke was hoping that this wealth effect would generate an economic recovery, with high-end consumers starting to spend and the companies that sell to them hiring workers and increasing their capital spending.

But QE1 and QE2 clearly failed to ignite a sustainable recovery and Bernanke recognises that QE3 will be equally futile. He knows that QE3 simply won't work at a time when consumers, worried about their job prospects, are cutting back on spending, and businesses, worried about future sales, are wary of investing or hiring new workers. Even worse, he knows that QE3 will spill over into commodity markets, driving up the oil price, and that higher oil prices will squeeze the profit margins of small and medium-sized US companies and force consumers, who have to spend more to heat their houses and drive their cars, to cut their spending on non-essential items.

Still, investors know that the only success Bernanke can claim in the post-crash environment is that he's been able to generate financing asset inflation – higher prices for shares and bonds. And they realise that he'll be deeply reluctant to forfeit his only achievement, flimsy though it is. As a result, they're already driving up the prices of financial assets in the expectation of another round of QE3.

But the big problem for Bernanke is that QE3 is already being priced into share and bond markets. This creates the risk that the actual announcement could fail to further boost equity markets, or to push US bond yields even lower. The US central bank could suffer a damaging loss of credibility if investors conclude that it is impotent, not only in terms of its ability to stimulate the economy, but also in terms of its ability to push equity and bond markets higher.

Over in Europe, the boss of the European Central Bank, Mario Draghi, faces a similar dilemma. He's under intense pressure to intervene to stop the crisis now engulfing Spain and Italy, which has sent their borrowing costs soaring.

So far investors have been dismayed that Draghi has refused to start buying up huge quantities of Spanish and Italian bonds, which would push their bond yields lower. It's not that this represents a novel approach – the ECB has, after all, spent €214 billion ($US260 billion) in the last two years buying up Greek, Irish, Portuguese, Spanish and Italian bonds, although it hasn't used this tool in recent months.

And they were concerned by the prim tone that Draghi adopted when he told Le Monde in an interview published on the weekend that it was not the ECB's role to solve the financial problems of debt-laden countries. But overnight, they became more optimistic that the ECB could be on the verge of relenting after an ECB board member, Ewald Nowotny, said there were "pro arguments” for giving a banking licence to the eurozone's new bailout fund. Such a step would allow the bailout fund to borrow from the ECB, and considerably increase the firepower it has at its disposal for rescuing troubled eurozone countries.

Nowotny's comments were significant because the ECB has repeatedly rejected the suggestion that it should lend to the eurozone's bailout fund. For investors, the comments were a clear signal that the ECB is now gearing up to play a much bolder role in fighting the eurozone's debt crisis.

Investors are deeply aware the ECB is currently the only European institution capable of stemming the crisis. The eurozone's new €500 billion bailout fund won't be up and running until mid-September at the earliest because of the legal challenge in Germany's Federal Constitutional Court in Karlsruhe. And the existing bailout fund has less than €250 billion – and some of these funds are already ear-marked for the Spanish banks and for Greece.

That's why they're betting that Draghi – despite his reservations over the ECB's proper role – will ultimately conclude he has no option but to act.