MONEY MARKETS-Libor watchers mull Fed mortgage debt buys

* Fed program to buy mortgage debt ignites rally in credit

* Dollar interbank rates rise, spreads stay wide

* Lower rates expectations soothe euro, sterling Libor

By John Parry and George Matlock

NEW YORK/LONDON, Nov 25 (Reuters) - A key test of credit market sentiment will be how interbank lending markets react to Wednesday's Libor fixing to the U.S. Federal Reserve's latest lifeline to languishing credit markets: a plan to directly buy $600 billion of mortgage-related assets.

Libor, or the London interbank offered rate -- the world's leading benchmark for short-term borrowing costs off which loans are benchmarked -- is a key barometer of sentiment in bank-to-bank lending markets, although many financial institutions are hoarding cash.

The pernicious effects of the biggest financial crisis in many decades persist, as many banks are loath to make near-term loans for fear they might not be repaid, and as year-end accounting intensifies cash needs.

"This is a further step into quantitative easing. They are buying debt to keep long-term rates and spreads low," said Rudy Narvas, senior strategist at 4Cast Ltd in New York. "They have been doing quantitative easing lite."

The Federal Reserve's bold step to buy housing-related assets ignited a huge rally in U.S. mortgage-related securities, bringing yield spreads over comparable Treasuries down sharply from near-record highs.

Banks' exposure to housing-related assets has been at the center of the global financial system's troubles, triggering hundreds of billions of dollars of write-downs since the credit crisis erupted in the summer of 2007.

Any sustained rally of mortgage securities would help fill some of the holes in banks' balance sheets, but it remains to be seen if this will translate into an easing of the still deep distrust among financial institutions in bank-to-bank lending.

Interbank dollar lending rates rose in Europe on Tuesday and spreads between those and policy rates stayed wide as banks braced for strains at the end of the calendar year and Citigroup's bailout raised new worries about banks.

Concerns about banks' end-of-year funding contrasted with the more immediate financial sector relief after Citi's rescue and the U.S. Federal Reserve's announcement on Tuesday of the $600 billion program to buy mortgage-related debt and $200 billion facility to support consumer debt securities. For full story, see [ID:nN25483040]

A sharp gain in banking shares pulled up broader U.S. and European equity markets.

"The equities are rising because the Fed package and Citigroup rescue are seen as solutions, but Libor rates are looking the other way because this is just creating a solution with more credit," said Peter Mueller, interest rate strategist at Commerzbank in Frankfurt.