By Natsuko Waki
LONDON, Feb 8 (Reuters) - Investors are testing the enthusiasm of central banks to cut interest rates, with laggards in the race to zero facing heavy pressure on currencies.
Zero interest rates work to encourage investors to get out of cash, other liquid assets and safe government bonds -- where they earn zero yields -- and move up on a risk curve to buy instruments that give higher returns, such as equities or higher-quality credit notes.
Moreover, as central banks reach zero policy rates and begin to ponder more quantitative easing policies of buying shares, credit or mortgage-backed securities, investors will also be encouraged to take part in such buying, which in turn help boost risk assets in the long term.
"Quantitative easing represents new opportunities. The ones attempting to be the most aggressive give investors more incentives to go with the flow where a policy shift is taking place -- be it MBS or credit," said Michael Dicks, head of investment strategy at Barclays Wealth.
"People are looking at what they are getting on deposits. 'How do I stretch to get a decent yield? The central bank is leaving me with no income.' This is leading people to take more risk."
The top runner in the game of reaching zero so far is the U.S. Federal Reserve, which in December cut the cost of borrowing to near zero.
Japan comes in a close second as rates are at 0.1 percent. It also pledged last week to buy up to $11 billion in shares held by banks. Britain has just cut to 1.0 percent, the lowest in the more than 300-year history of the Bank of England.
The laggard is the European Central Bank, whose cost of borrowing at 2 percent is the highest in the Group of Seven major economies. The ECB said zero interest rates were not an option for now given the drawbacks, although it did signal the bank would probably cut rates again in March.
EURO MISERY
A lower interest rate in theory makes holding a currency less attractive.
However, investors are now punishing the euro, as they bet that economic conditions will deteriorate enough to prompt the ECB to cut interest rates aggressively.
Interest rate futures now show implied UK rates in March standing 10 basis points above that of the euro zone. This compares with expectations back in December that UK implied rates would be 75 bps below the euro zone.
Sterling shot up by almost 9 percent versus the euro in the past two weeks -- scoring one of the biggest fortnightly gains since mid 1995. It hit a record low near parity in December.
The euro is the biggest loser this year, falling around 7-8 percent against the dollar, sterling and the yen.
"The main asset that is affected by this theme is the euro. There's less need to look for other assets," Dicks said.
Elsewhere, "we see what policymakers are trying to achieve and now they are telling us the precise action."
The Fed unveiled a $600 billion programme to buy mortgage-related debt and securities and a $200 billion facility to buy consumer debt securities in November. In January, it said it stood ready to buy long-term U.S. government bonds.
"Our greatest focus is on opportunities in parts of the equity markets where policy support is the most direct," Goldman Sachs said in a note to clients.
Its housing basket trade -- which bets on a recovery in the housing market -- has risen 12 percent after a sell-off in January.
FIRST IN, FIRST OUT
Goldman's model on an optimal real interest rate shows a Fed funds rate of minus six percent by the end of 2010. Since a negative funds rate is impossible, this means the Fed will need to make heavy use of quantitative easing over the next two years to return inflation and growth to their target levels.
A similar calculation in the euro zone suggests that the ECB will hit the zero bound by the middle of this year, while in the UK the policy rate will be negative by mid-2009, assuming no change in potential output growth.
According to corporate earnings estimates, the United States and Britain currently have largest expected falls in earnings of up to 11-12 percent, allowing investors to price that in the stock market. The forecast for euro zone earnings is still positive.
"When you are unsure about the efficacy of monetary policy measures in the context of recession, you should not run the risk of not doing enough. You should do the opposite and go big time," said William De Vijlder, chief investment officer at Fortis Investments in Brussels.
"That's the view that has been reiterated by the Fed, and that is underpinning the stance of the BoE. It's clearly my preference that the central bank goes in pretty aggressively."
Seventy-nine percent of clients surveyed by Goldman Sachs expected the United States to recover before Europe, compared with 15 percent who expected a simultaneous recovery and six percent who reckoned Europe would recover before the United States.
"There is also consideration of first in, first out. The U.S. is the first to go into the recession and may be the first to go out. This is where the most overwhelming measures are taken," De Vijlder said.
(Editing by Ruth Pitchford)