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UPDATE 1-US commercial paper market shrinks for 3rd week

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NEW YORK, July 30 (Reuters) - The U.S. commercial paper market contracted for a third straight week, eroded by the global credit crisis and protracted economic downturn, Federal Reserve data showed on Thursday.

For the week ended July 29, the size of the U.S. commercial paper market, a vital source of short-term funding for routine operations at many companies, fell by $27.6 billion to $1.066 trillion outstanding, from $1.093 trillion outstanding the previous week.

The market is the smallest since at least early 2001, when the Federal Reserve began compiling data in its current form.

Companies and banks’ reliance on commercial paper for short-term borrowing has diminished because of the shock from the credit crisis, alternative sources of cheap government money from emergency lending programs, and waning demand amid the most brutal recession in decades, analysts say.

Typically, signs that the economy might be bottoming, which some economists see now, would dovetail with an upturn in commercial paper issuance -- which companies often use to restock shelves or hire workers in anticipation of rising demand.

But this time, the market has been fundamentally altered, perhaps permanently. Banks and companies are getting so used to seeking alternative sources of short-term funding, that commercial paper may not immediately mirror the economy’s fortunes, some analysts say.

The market has shrunk dramatically, to half the peak of some $2.2 trillion outstanding in August 2007 when the credit crisis erupted.

“We don’t necessarily need to see commercial paper turn to signal a turn in the economic cycle,” said Howard Simons, strategist with Bianco Research in Chicago. “If the recession is not over, it is not getting worse and at some point credit demand has to rise.”

Asset-backed commercial paper outstanding rose by a modest $900 million in the latest week to $437.8 billion outstanding, after falling by $4.6 billion in the previous week.

This subsector of commercial paper reflects demand for mortgages, which were at the epicenter of the global financial crisis as the U.S. housing market started to slide.

However, even after some recent data signaled that a bottom for the U.S. housing market may now be in sight, Simons is skeptical that the mortgage-related parts of the commercial paper market will recover much.

Banks and other financial institutions’ shift away from short-term funding in the commercial paper market was reflected in the latest week’s data. Unsecured financial issuance outstanding fell by $26.6 billion in the latest week, after rising by $2.7 billion the previous week. (Editing by Leslie Adler)