UPDATE 1-US commercial paper outstanding least since 2004

(Adds analyst quotes, more context)

NEW YORK May 7 (Reuters) - The U.S. commercial paper market contracted to its lowest level outstanding in more than four years as the deep economic downturn continued to erode it, Federal Reserve data showed on Thursday.

For the week ended May 6, the size of the U.S. commercial paper market, a vital source of short-term funding for daily operations at many companies, fell by $43.2 billion to $1.379 trillion outstanding, the lowest level since December 2004 according to Reuters data.

The overall U.S. commercial paper market peaked at about $2.2 trillion outstanding in August 2007, just as the credit crisis broke out.

"Fundamental factors are at work. The economic prospects are not yet that encouraging," said Kenneth Kim, economist with Stone & McCarthy Research Associates, in Princeton, New Jersey.

"Even if the recession is over in the next few months, there is still the question of how robust the recovery will be," Kim said.

Companies typically borrow in commercial paper markets to rebuild inventories in anticipation of rising sales, and for routine expenses such as payroll.

"Without a better sense of guaranteed recovery, businesses will still be cautious, as the commercial paper data reflect. Companies don't want to be the first out there spending money," Kim said.

Asset-backed commercial paper outstanding contracted by $22.8 billion in the latest week after shrinking by $25.8 billion the previous week.

Unsecured financial issuance outstanding fell $21.5 billion after contracting by $18.7 billion the previous week. (Reporting by John Parry; Editing by James Dalgleish and Jeffrey Benkoe)