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INVESTMENT FOCUS -Exploiting the ECB-Fed policy gap

LONDON, June 6 (Reuters) - If it wasn't fully apparent before Thursday, it's crystal clear now: the central banks of the euro zone and United States, the two most powerful monetary authorities in the world, are moving in opposite directions.

What's less obvious is whether the flood of measures the European Central Bank has just announced will strengthen or weaken the trend this year for Europe's stocks, bonds and main currencies to broadly outperform their U.S. counterparts. Earlier this week, the gap between some of these European and U.S. prices reached their widest in years.

Thursday's ECB measures include a historic cut taking its overnight deposit rate below zero and 400 billion euros ($545 billion) of cash for banks to lend on in a campaign to defuse the threat of deflation, revive corporate borrowing and spark growth across the 18-nation bloc.

Across the Atlantic, meanwhile, the Federal Reserve is on track to close out its bond-buying program later this year, winding down stimulus. If the economic recovery doesn't falter, it could start raising interest rates next year.

Euro zone banks and investors unwilling to pay for the privilege of depositing cash at the ECB dumped their euros for dollars on Thursday. This pushed the premium to access dollars in the forward currency market, measured by benchmark three-month cross currency basis swaps, to its highest since June last year.

In government bond markets, where the connectedness of global economies has historically forged close trading relationships between major debt benchmarks, an anomaly has emerged. The difference between the yield on two-year U.S. Treasuries over comparable German bonds rose to 35 basis points, the widest gap in seven years .

The questions now for investors are: is there any juice left in these trades? If so, how much? Where are the most lucrative areas to play this policy divergence?

Traders say that many large financial institutions are now selling U.S. Treasury bonds of maturities out to 10-years and buying German equivalents to take advantage of the differing official rates outlooks.

"It is clear that the ECB is at a very different stage of the cycle than the Fed and thus, on a relative value basis, the European bond market still looks like the place to be," said Gary Jenkins, strategist at LNG Capital in London.

The prospect of another wave of European liquidity and investors' hunt for yield matched perfectly on Friday. The yield on 10-year Irish, Spanish and Italian government bonds plunged to their lowest levels ever. Remarkably, less than four years after having to seek an international bailout, Ireland can now borrow for 10 years at cheaper rates than the United States.

STOCK & ROLL

It is not just bonds that present opportunities.

"This could still be constructive for equities and other growth assets relative to government bonds," said Neil Williams, chief economist at Hermes Fund Managers in London.

"But it's too little to late to snuff out the deflation risk. The ECB will have to capitulate eventually and do full-blown QE (quantitative easing). The ECB has overpromised. The big risk is that it underdelivers," he said.

Germany's DAX popped above 10,000 points for the first time ever immediately after the ECB's action on Thursday. But Wall Street has been printing record highs on a near daily basis for weeks.

The daily correlation between the S&P 500 and DAX hit 0.949 this week, its highest in three months. But bearing in mind the highest possible correlation is 1:1 suggests that correlation will soon start to weaken, as it has done consistently over the last 20 years at these lofty levels.

Williams reckons the U.S. economy will grow faster than the euro zone over the next couple of years so Wall Street should outperform euro zone stocks, despite the ECB's more market-friendly stance.

Others, such as Brian Jacobsen, portfolio strategist at Wells Fargo Asset Management, said U.S. investors are becoming increasingly "intrigued" by opportunities in European markets. He would be prepared to go "heavily overweight" into European stocks, he said.

The ECB's impact on foreign exchanges was fleeting. The euro initially plunged a cent to a four-month low around $1.35 , only to snap back and end the European trading day higher.

The conventional wisdom is that the ECB's drive to push monetary policy in the opposite direction to that of other major central banks like the Fed and bank of England should pressure the euro to weaken.

But the ECB's policy measures will attract foreign investment into European assets, which will put upward, not downward, pressure on the currency.

"You've got a lot of conflicting pressures. The short euro, long dollar trade has been one that people have had on since the beginning of the year and it has not played at all well," said said David Riley, head of credit strategy at Bluebay Asset Management. ($1 = 0.7345 Euros)

(Graphic by Vincent Flasseur; Editing by Ruth Pitchford)