MONEY MARKETS-Dollar funding strains still high in euro zone

* Dollar funding costs for euro zone banks rise further

* May ease if ECB's cash injection proves effective in 2012

* Short-term euro rates seen drifting lower

By Marius Zaharia

LONDON, Dec 22 (Reuters) - A key measure of dollar funding strains for euro zone banks widened on Thursday, as the supply of greenbacks to money markets remained scarce relative to the massive boost to euro liquidity from the ECB.

Traders said the banks' usual higher cash needs before the end of the year were delaying any improvement in interbank markets after the European Central Bank pumped almost half a trillion euros in three-year loans on Wednesday.

The euro/dollar cross currency basis swap, which widens when lenders charge more for swapping euro interest payments on an underlying asset into dollars, expanded across the curve.

"Banks will take the euros and swap it back into dollars in the 3-year maturity, widening the basis. That seemed to drag the front end of the curve along with it," said Ciaran O'Hagan, rate strategist at Societe Generale.

Long-term euro financing from the ECB followed by a dollar swap is one way for banks to offset a U.S. money market funds exodus from Europe, but they also have unlimited one-week and three-month dollars available with the ECB via its swap line with the Federal Reserve.

The 10 biggest prime money market funds reduced their overall European exposure by 4 percent in November from October, according to a Fitch report released on Wednesday. Since the end of May with the flare-up of the region's debt crisis, they have lowered their European debt holdings by 45 percent, Fitch said.

The three-year euro/dollar FX basis swap was last minus 78.25 basis points, some 5 basis points wider from levels seen before the ECB tender. The three-month swap was about 15 bps wider from before the euro injection at minus 135 bps.

But the cheap euros banks took from the ECB will help them refinance their maturing debt, which may at least slightly increase the confidence levels in interbank markets, traders said. Dollar funding stress may thus ease early next year after banks cover their end-year needs.

"There's going to be some year-end pressures," said Ian Stannard, head of FX strategy at Morgan Stanley. "Once we get through the year-end we could well see some relief and a narrowing (of the three-month FX basis) to the 80 bps area."

"The liquidity operations are going to help."

The 80 basis points level was the breakout point during the latest escalation of worries over euro zone sovereign debt and the implications a worsening of the crisis would have on banks holding bonds issued by countries such as Italy or Spain.

FALLING RATES

The massive liquidity injection and the prospects of a large take-up of new three-year ECB funds in February should keep overnight EONIA rates at levels close to the deposit facility rate at 0.25 percent.

If funding strains ease as well, that is likely to be reflected in narrower spreads between Euribor of Libor rates and overnight index swaps.

Morgan Stanley recommends buying the March 2012 Euribor contract, either outright or versus paying March Eonia .

Some technical analysts also recommend buying March Euribor, which they say it is on a tentative rising trendline and could test the September highs at 99.07, compared to 98.83 currently.

The three-month euro London Interbank Offered Rate, or Libor , fell to 1.33929 percent from Wednesday's 1.34571 percent. The dollar Libor rate, however, rose to 0.57375 percent from 0.57125 percent.