MONEY MARKETS-Dollar Libor fall conflicts with euro rate

* Dollar rates down, euro Libor up

* ECB borrowing down as liquidity squeeze buoys rates

* Stress test seen easing credit risk but only over time

By Burton Frierson and William James

NEW YORK/LONDON, July 27 (Reuters) - Bank-to-bank dollar borrowing costs fell on Tuesday, but euro rates rose as the calming effect of Europe's stress tests was postponed in the lending market.

Analysts said direction of benchmark euro Libor rates ran contrary to the general sense of relief that Europe's stress tests had inspired but was related to a retreat from emergency lending measures, not worries over banks.

They said dollar Libor rates were more typical of the fundamental backdrop, which is one of easy monetary policy and little likelihood of a race to hike borrowing costs any time soon.

Though it may take some time, euro rates will respond to these monetary policy influences as the effects of the stress tests slowly dissipate worries of recent months that Europe's budget woes could ultimately wreak havoc on the financial sector.

"The European Central Bank, the Bank of England and Federal Reserve, none of them are set to raise rates any time soon. So that should keep downward pressure on Libors over the course of the summer," said Andrew Wilkinson, senior market analyst at Interactive Brokers Group in Greenwich, Connecticut.

"The stress test results as they stand are a positive development for the cash market, but it's not going to change overnight. It's going to take possibly a couple of quarters of seeing improving bank results before lenders will be more willing to lend to one another."

The benchmark three-month dollar Libor rate USD3MFSR= fixed at 0.48125 percent versus 0.48750 percent on Monday.

EURO CONTRAST

In contrast, three-month euro Libor EUR3MFSR= edged higher to 0.82750 percent to reach an 11-month high.

Banks' borrowing from the European Central Bank fell on Tuesday, adding to demand for funds in money markets continuing to push rates towards normalization as emergency ECB liquidity measures are withdrawn.

However, the risks associated with interbank lending showed early signs of easing with banks now able to conduct their own stress tests using data disclosed last Friday as part of a wide-ranging health check on European institutions.

Still, the easing in the perceived riskiness of lending to other banks, which under normal market conditions would cause rates to fall, was outweighed by the prospect of an end to extraordinary liquidity measures, which puts upward pressure on lending rates.

"The front end is a function of the stealth hike which the ECB is implementing continuously and gradually by phasing out the unconventional (liquidity) measures," said Matteo Regesta, strategist at BNP Paribas.

Interbank lending rates have been kept artificially low by an unlimited supply of European Central Bank money pumped into the system to keep banks lending to each after the 2008 collapse of Lehman Brothers.

As the ECB slowly withdraws that liquidity by not renewing offers of long-term loans, more banks are turning to money markets for funding, with the increased demand causing rates to climb towards the central bank's 1.0 percent refinancing rate.

At its regular weekly unlimited tender, 201 billion euros of ECB loans expired and banks opted to renew only 190 billion euros, resulting in a fall in excess liquidity.

The easing risk aversion was shown by a slight tightening of the three-month euro Libor-OIS spread, which measures the risk premium banks factor into lending rates by discounting market expectations of central bank rates. The spread narrowed by around 1 basis point to 23 bps.

Interbank lending remained heavily segmented, however, with some lower-rated banks continuing to pay higher rates. The 16 banks contributing to the three-month euro Libor fixings show a 19 basis point spread on the rates at which they believed they could obtain funding. (Editing by Kenneth Barry)