Money markets us commercial paper market shrank in latest week

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* Businesses prefer longer term borrowing* Some firms have found alternate funding sources* Euribor rate falls to lowest since July 2010* Euribor/OIS spreads seen stabilizing around 20-30 bpsBy Ellen Freilich and Ana Nicolaci da CostaNEW YORK/LONDON, March 22 The U.S. commercial paper market contracted in the latest week, suggesting a pullback in short-term business borrowing even as data offered evidence of a strengthening economy, according to Federal Reserve data released on Thursday. In the week ended March 21, commercial paper outstanding fell $5.6 billion to $931.2 billion on a seasonally adjusted basis, the Fed said. U.S. non-seasonally adjusted foreign bank commercial paper outstanding fell $300 million in the same week. U.S. non-seasonally adjusted commercial paper outstanding fell $2.3 billion. On Thursday, the U.S. Labor Department said the number of Americans claiming new unemployment benefits dropped to a four-year low last week, offering further evidence the job market was gaining traction. Commercial paper "is just a smaller market than it used to be," said Terry Sheehan, economic analyst at Stone & McCarthy Research Associates in Princeton, New Jersey. "Some companies found alternate funding sources so commercial paper hasn't (recovered from the recession) as much as it might have otherwise."In addition, with the approach of the quarter-end, "risk aversion tends to set in so the declines in commercial paper (issuance) could be related to that," Sheehan said.

Recent upticks in rates might also have encouraged firms to seek longer term borrowing opportunities in order to lock in lower rates when they can, she added, noting that is possible because banks are lending more than they did in the immediate aftermath of the financial crisis. Still, "overall, lending isn't what it was, and that's consistent with the lower level of economic activity that we've seen these last few years," Sheehan said. Overseas, bank-to-bank Euribor lending rates fell on Thursday amid ample liquidity. Analysts said short-term rates could stabilize near record lows since the European Central Bank is expected to keep interest rates steady for a while. Three-month Euribor rates fell to 0.817 percent - the lowest since July 2010 - from 0.824 percent on Wednesday. One trillion euros worth of cheap three-year ECB funding has pulled the rates back from the 1.42 percent level they were at before the central bank's first injection in December. Euribor futures show the three-month rate should fall to around 0.64 percent in June or September - near record lows of 0.63 percent seen in March of 2010.

"It seems that June or September Euribor are pricing a level of Euribor which is as low as it can get if the European Central Bank doesn't cut the deposit rate," Corentin Rordorf of Morgan Stanley said. Since the rate offered at the ECB's deposit facility is currently at 0.25 percent, overnight Eonia rates at 0.35 percent are not expected to ease much further. Given that a three-month borrowing rate has to offer some premium over overnight lending costs, Euribor rates of 0.64 percent, offering roughly a 30 bps premium over the current Eonia rate, cannot fall much further either, Rordorf said. ECB BUFFER

Simon Smith, chief economist at FxPro also saw the three-month Euribor/OIS spread - a measure of counterparty risk - stabilizing around 25-30 basis points, as the ECB is expected to keep borrowing costs on hold for at least the next year. A Reuters poll published last week shows economists expect the ECB to keep interest rates at a record low of 1.0 percent through all of this year and next, after the ECB warned about inflation risks at its last monetary policy meeting."The ECB has been relatively clear, not explicitly saying but giving the impression that it doesn't really have any inclination to move rates lower," Smith added. "There's probably a bit further to run in terms of those short-end contracts but not that much further."The ECB earlier this month raised its forecasts for inflation this year.. Another flare-up in the euro zone debt crisis could cause measures of counterparty risk to widen. Market players are increasingly worried about the fiscal situation in Spain, and they do not rule out further bailouts for Greece and Portugal. Ten-year Spanish/German government bond yield spreads have widened some 40 basis points since the beginning of the week. A widening in the spreads of peripheral debt over their German counterparts could prompt a rise in measures of counterparty risk. But Alessandro Giansanti, senior rate strategist at ING said any impact would be offset by improved funding conditions for banks after the two ECB cash injections, limiting any fall-out. Indeed, excess liquidity in the financial system could take the Euribor/OIS spread as far as 20 basis points, he said."When you know that every bank can access unlimited funding from the ECB, from the national central bank, do you really need (such a big) risk premium in this environment?" he said.