ECB hints at cuts as money market strains worsen

NEW YORK (Reuters) - The European Central Bank on Thursday signaled it might cut interest rates for the first time in five years as credit strains paralyzed money markets.

Interbank lending rates extended their upward march, reflecting tightness in credit markets, while a sharp fall-off in U.S. commercial paper issuance indicated businesses were having an extremely difficult time raising short-term capital.

ECB President Jean-Claude Trichet, speaking after the central bank left rates unchanged, highlighted further risks to the European economy from the credit crunch, suggesting the once inflation-leery official was warming to the idea of bringing rates down from the current 4.25 percent.

Trichet said ECB policy-makers recognized "the extraordinary high level of uncertainty stemming from latest developments" on turbulent financial markets and the credit crunch. "Economic activity in the euro area is weakening with contracting domestic demand and tighter financing conditions," he said.

"The ECB is adopting a substantially softer tone, which opens the door for a future interest rate cut," said Howard Archer, chief European economist at Global Insight.

The Wall Street Journal reported that U.S. Federal Reserve officials are weighing further interest rate cuts, even if Congress approves a $700 billion financial industry bailout, because of a worsening economic outlook.

A rate cut is still far from certain, partly because of inflation worries, the WSJ said in an unsourced report on its website.

The change in the ECB's tone reflected a rapid deterioration in the global credit situation. The year-long crisis has seen the downfall of such staple corporate names as Lehman Brothers and AIG, and bank failures have become frequent.

Markets were still on edge as the U.S. House of Representatives prepared for a Friday vote on the $700 billion bailout package that was approved by the Senate on Wednesday night.

Three-month dollar Libor rose to 4.20750 percent, its highest since January, up from 4.15000 percent on Wednesday. The euro-zone equivalent for euros hit its highest since the launch of the single currency, at 5.31750 percent.

Analysts were leery about funding pressures, saying they could remain high even if the U.S. legislation passes.

Meanwhile, the U.S. commercial paper market ground to a screeching halt as mistrust remained at the highest levels since the crisis began in the summer of 2007.

Commercial paper outstanding dived by $94.9 billion to $1.607 trillion, from $1.702 trillion the previous week, Federal Reserve data showed. That brings the cumulative shrinkage of this market to $208 billion in the last three weeks.

The market has lost over a quarter of its value since the start of the crisis, with asset-backed issuance, seen as most closely linked to the downtrodden real estate sector, shrinking even more.

In one pocket of relief, overnight dollar Libor rates fell more than a full point to 2.68125 percent from 3.79375 percent on Wednesday while euro overnight rates also eased.

Still, the spread of three-month London interbank offered dollar rates over Overnight Indexed Swap rates, seen as a gauge of banks' willingness to lend to each other, blew out to its widest at least since the credit crisis began more than a year ago, at 260.7 basis points, from 245.25 basis points on Wednesday. A wider spread indicates reluctance to lend.

Stock markets around the world were falling rapidly on fears about a possible rejection of the U.S. rescue package. The House of Representatives shot down a different bailout bill earlier in the week.

U.S. Treasury bonds reflected investors' penchant for safety in uncertain times. The 30-year Treasury bond was up over a full point in price and offering a yield of 4.16 percent, down more than 30 basis points from highs set last week.

(Additional reporting by Marc Jones, Chris Reese, Emelia Sithole-Matarise and Kevin Plumberg in London; Editing by Dan Grebler)