(Updates with U.S. rates, comments)
* U.S. short-term rates firmly anchored near zero
* Fed sees funds rate near zero at least through late 2014
* Interbank lending rates continue fall
NEW YORK (Frankfurt: A0DKRK - news) , Jan 27 (Reuters) - U.S. short-term interest rates were locked more tightly than ever to near zero on Friday, responding to the Federal Reserve's plan to keep its key federal funds rate exceptionally low at least through late 2014.
The Fed's move came at the end of a two-day policy meeting earlier this week. With the European Central Bank allowing euro zone banks to borrow money at low rates for a three-year period, the moves on both sides of the Atlantic (Stuttgart: A0J3C9 - news) point to a long period of low interest rates ahead.
"The Fed has put the playbook in investors' hands, and it's by design," said Paul Montaquila, vice president for fixed-income at San Francisco-based Bank of the West. "The Fed does not want investors in the bill market or the short-term Treasury market. The Fed wants investors out on the curve and in risk assets."
On Friday, three-month U.S. bills yielded 6 basis points, six-month U.S. bills yielded 8 basis points, and 1-year bills yielded 11 basis points. Even two-year notes yielded just 22 basis points and three-years 31 basis points.
"By extending the period that it is likely to be on hold, the Fed is sending investors farther out on the curve, which helps lower long-term rates and increases risk appetite, ultimately having a positive impact on financial markets and the broader economy," said Chris Molumphy, chief investment officer of the Franklin Templeton Fixed Income Group in San Mateo, California.
Overseas, three-year loans to banks at low rates by the European Central Bank have reassured investors and allowed countries such as Spain and Italy to sell debt at lower cost. On Tuesday, Spain sold three-month and six-month paper at the lowest yields since February and June, respectively.
On Friday, Italy sold six-month debt with yields of 1.97 percent, well below the 3.25 percent it paid a month ago and dramatically lower from the euro lifetime record 6.5 percent investors demanded at an auction in November (Stuttgart: A0Z24E - news) .
"A one-percentage point drop in the average T-bill yield reduces interest payments by around 4 billion euros over a year," said Intesa Sanpaolo (Dusseldorf: 575913.DU - news) analyst Chiara Manenti.
"The ECB is doing everything they can to try to calm the situation," said Anthony Lazzara, managing partner at M&N Trading in Newport Beach, California. "A lot of volatility has come out of the market."
Still, U.S. money funds remain cautious about lending to banks in the euro zone even as liquidity in the region improves and as signs emerge that some investors may be taking small steps back into the region.
"Given the experience of U.S. based money funds in the 2008-2009 U.S. crisis, it wasn't surprising that most did step back last year when the European financial crisis was deepening," Molumphy said.
But the ECB loans to euro zone banks won't cure that wariness overnight, he said.
"Certainly the ECB term financing is a very positive step in the right direction, but the resumption of U.S. buyers of euro zone debt in size will likely time," he said. "The 2008-2009 experience when money funds 'broke the buck' is still fresh and will take an extended period of time to get over."
At an investment outlook presentation in New York on Thursday, William Kohli, co-head of fixed income investment management at Putnam Investments, concurred.
"There will be investment opportunities in European sovereign debt at some stage, but it's still too early in that process to step in," he said.
The ECB tender solved a lot of structural issues, he said.
"It puts a lot of salve on the wounds near-term and that relieves a lot of the funding pressures," Kohli said.
Kohli said Putnam money market funds have not moved back into the euro zone.
"If (euro zone) banks have unfettered access to capital markets, that will take a lot of stress out of that market," he said. "That will change those dynamics, so we'll stay in that conversation. But we have not stepped back in yet."
Euro zone interbank lending rates fell again on Friday and analysts said rates had plenty of room to slide further given the banking system's ample excess liquidity, even before the ECB offers banks more three-year funding next month.
Benchmark three-month Euribor rates fell to their lowest level since March 2011 at 1.138 percent, down from 1.142 percent in the previous session. The rate has fallen more than 30 basis points since the ECB said in December it would offer banks three-month funding with a take-up of almost half a trillion euros of the cash and another such tender at the end of February.
With the three-month Euribor rate falling just over a basis point a day on average since banks got the cash, the forward rate implied by the March Euribor future of 0.95 percent still holds significant downside potential, Commerzbank (EUREX: CBKF.EX - news) strategist Christoph Rieger said. (Reporting By Ellen Freilich and Kirsten Donovan; Editing by Padraic Cassidy)
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