LONDON, March 1 (Reuters) - Euribor lending rates hit their lowest level since October 2010 on Thursday and were likely to fall further after the European Central Bank injected another bout of cash into the financial system to restore confidence in the struggling banking sector.
Banks snapped up 530 billion euros at the ECB's second offering of cheap three-year funds on Wednesday. The extra liquidity will not solve the underlying debt problems in the euro zone, especially as banks increasingly hoard the cash, but it should stave off a credit crunch.
The abundance of cash is expected to push key measures of interbank financial stress towards levels seen before the ECB began buying Italian and Spanish bonds in August 2011 to cap a surge in funding costs as market worries about peripheral euro zone debt escalated.
Three-month Euribor rates fell to 0.967 percent from 0.983 percent, hitting the lowest level since October 2010.
Simon Smith, chief economist at FxPro, expected the spread between 3-month Euribor and overnight Eonia rates, a measure of counterparty risk, to fall to about 40 basis points by May from around 62 bps currently. The spread was at 35 bps at the beginning of August.
"It is more likely that we find a floor to that spread in its convergence with those of other major markets, such as the dollar market," Smith added.
The U.S. dollar Libor/OIS spread stood at 41 bps.
But Smith also stressed that the euro zone's underlying problems remained.
"The first round (of LTRO) was all about removing the tail risks of a full-scale credit crunch in Europe and it was successful in doing that and reducing the fears about bank refinancing needs ... I think there is a lot more uncertainty with regards to where this one is headed," he said.
Alessandro Giansanti, senior rate strategist at ING, said the improvement in funding conditions resulting from the ECB's second three-year long-term refinancing operation (LTRO) could take the Euribor/OIS spread to 30 to 40 bps over the next month.
That would be the floor, he added, because investors would still require a premium for lending cash for three months as opposed to overnight. The overnight Eonia rate at 0.37 percent could not fall much further given it was already close to the 0.25 percent rate offered by the ECB deposit facility, he said.
The ECB's liquidity boost has helped stabilise the banking sector and eased tension in financial markets but has yet to filter through into the real economy.
Indeed, ECB President Mario Draghi urged banks on Sunday to help strengthen economic growth by lending the money they borrow from the central bank at very low rates to euro zone households and businesses.
The euro zone's manufacturing sector contracted for the seventh straight month in February, a business survey showed on Thursday. Many fear the austerity measures aimed at reigning in debt levels could choke growth.
Meanwhile, the huge cash boost for euro zone banks was a factor behind economists' decision to reverse their forecasts for interest rate cuts this year.
The ECB is now expected to keep rates on hold at 1.0 percent until deep into 2013, a Reuters poll of economists showed on Thursday.
"I think (the ECB is) in the realms of liquidity versus interest rate cuts," a trader said. "If the ECB cuts by 25 bps, will the banks pass it on? Probably not. So why do it?"
Euribor futures <0#FEI:> are pricing in no rate cut in March and a 50 percent chance of a 25 basis point rate cut in June, Giansanti added. That was little changed from market expectations before the LTRO, he said, because that had been widely priced in already. (Editing by Susan Fenton)