* Treasury bills fall on Fed discount rate hike
* Fed funds futures point to more bets on hike by Sept
* Dollar Libor rates edge up after Fed discount move (Recasts; changes byline, dateline, previous LONDON)
NEW YORK, Feb 19 (Reuters) - Investors on Friday ramped up bets on a rate hike later this year and pulled up yields on Treasury bills, after last night's move by the U.S. Federal Reserve to raise emergency borrowing costs for banks surprised markets.
The Fed took its discount rate to 0.75 percent from 0.5 percent, but said this was not a precursor to a tightening cycle.
"The discount rate move is part of a normalization process, which is akin to our discontinuing many of our liquidity programs," St. Louis Federal Reserve Bank President James Bullard told reporters on Thursday.
"And it does not indicate anything one way or the other about what we might eventually do with the federal funds rate," he added. For details see [ID:nN18246964]
This week, fed funds futures contracts <0#FF:> had perfectly priced in a rate hike of 25 basis points by November.
But on Friday investors saw greater chances of a tighter fed funds rate earlier in the year. Treasury bills fell on the news as well.
Despite the Fed's characterization of the discount move as separate from monetary policy, "the market is taking quite a lot of effort to persuade," said David Sloan, chief economist North America at 4Cast in New York.
"I'm not sure it's appropriate."
Implied prospects that the Fed will raise its benchmark rate by September rose to 66 percent, from 54 percent before the Fed's announcement, based on the 4 p.m. Chicago time (2200 GMT) close of the September fed funds futures contract at the Chicago Board of Trade. [ID:nN18611988]
EUROPE AFFECTED
Dollar interbank rates edged up on Friday on the Fed news, as further signs of tightening credit conditions in the euro zone raised expectations that the European Central Bank will find it hard to unwind its extraordinary measures.
The difference in outlook for future interest rates saw the euro fall to a nine-month low against the dollar and December Euribor and Eurodollar prices converge to their tightest since May 2009 as the implied yield spread widened.
Three-month dollar Libor rates were slightly higher at 0.25194 percent, while equivalent euro rates also edged up to 0.60625 percent [ID:nEAP000041].
Greek repo remained closed for business this week and analysts said there were signs of caution in the Spanish market.
"The perceived risk of a Greek government default has been pushing Greek general collateral prices wider since mid-November, but it has been the lack of appetite to take on counterparty risk with the natural holders of that debt -- Greek domestic banks -- that has, over the past month, effectively frozen the market altogether," said ICAP strategist Chris Clark.
Central clearing systems remove this counterparty risk for Italian, Irish and Portuguese repo but for the Spanish, as with the Greeks, trades are settled on a bilateral basis. (Additional reporting by Kirsten Donovan in London; Editing by James Dalgleish)
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