MONEY MARKETS-Dollar rates hit record lows after Fed

*Interbank markets seemingly take Fed statement in stride

*3-mo dlr, stg, euro Libor rates fixed at record lows

*U.S commercial paper market contracts in latest week (Recasts, adds U.S. developments, adds byline, adds NEW YORK to dateline)

NEW YORK/LONDON, Aug 13 (Reuters) - The two-year old credit crisis continued to abate in short-term borrowing markets on Thursday, a day after the Federal Reserve hinted that central banks are readying to slowly withdraw liquidity from the global financial system.

The interbank cost of borrowing three-month dollar, euro and sterling funds set record lows, according to the latest daily fixing from the British Bankers’ Association.

Three month dollar Libor rates USD3MFSR= were fixed at 0.44000 percent on Thursday, down from 0.44969 percent. See [ID:nLD506754]. Libor or the London interbank offered rate is the leading benchmark off which global short term borrowing costs are set.

The Fed signaled on Wednesday it aims to end its purchases of government bonds by the end of October. The removal of the U.S. central bank’s prop to the government bond market runs the risk of spiking yields, which would hike borrowing costs for homeowners in the still fragile economy, analysts warn.

But interbank lending markets appear to be taking the prospect of gradual withdrawal of central bank liquidity in stride for now.

The three-month London dollar interbank offered rate over Overnight Index Swap rates narrowed to near 25 basis points - a level which former Federal Reserve Chairman Alan Greenspan recently said would indicate normal money market conditions.

The spread expresses the three-month premium paid over anticipated central bank rates, which is seen as a gauge of banks’ willingness to lend to each other. A narrower spread tends to show increased inclination to lend.

Of the three currency OIS spreads the dollar was the most significant, which was at its narrowest since August 2007, said David Keeble, global head of interest rate strategy at Calyon in London.

“It takes us back two years to the time when BNP Paribas started to have problems with some of its money market funds. Right back to the beginning of all of this,” he said.

“There is a lot of cash flying around and the falling Libor rates express that,” said Gianluca Salford, European fixed income strategist at JP Morgan in London.

“But while policymakers are sensing the improved economic outlook down the road, they don’t seem to be in any hurry to remove the liquidity,” he added.

The Federal Reserve left its policy rate unchanged in a range of zero to 0.25 percent on Wednesday, as expected, where it has been anchored since mid-December. The Fed said rates would likely remain near zero for an extended period. [ID:nN1272730].

One reason for central banks to keep benchmark rates near zero is the persistent dislocations in some sectors of debt markets at the tail end of the most severe credit crisis in decades.

The release of weekly Federal Reserve data on Thursday highlighted such aftershocks, showing that the size of the U.S. commercial paper market -- a sector which has shrunk by half since the onset of the credit crisis in summer 2007 -- contracted in the latest week.

For the week ended Aug. 12, the size of the U.S. commercial paper market, a vital source of short-term funding for routine operations such as payroll and restocking inventories at many companies, fell by $1.8 billion to about $1.075 trillion outstanding.

Yet there were signs that the banking sector was benefiting from the Fed’s support for the commercial paper market. Unsecured financial issuance outstanding rose by $12.1 billion after shrinking by $400 million the previous week.

“All this money is simply going to prop them up and the banks are able to issue more commercial paper,” which is a positive sign for that slice of the short term paper market, said Howard Simons, strategist with Bianco Research in Chicago.

However, Simons is concerned that as longer maturity U.S. government bond yields rise steeply, corporate borrowers may increasingly crowd into the short end of fixed income markets, such as commercial paper. Such a shift would carry the risk that should short dated borrowing rates later soar, banks and companies could become vulnerable, just as failed Wall Street banks did during the global financial crisis, Simons said.

With Germany and France, the first- and second-largest euro zone economies, reporting surprise recession-reversing economic growth on Thursday, market watchers are worried about what happens when interest rates have to rise. [ID:nLD331672]

“It remains to be seen to what extent this (lower Libor rate) turns out to be sustainable as there is still a risk that rates would bounce back sharply if central banks pull back out of their money market interventions even only to some extent,” said David Schnautz, a bond analyst at Commerzbank in Frankfurt. (Editing by Kenneth Barry)