By Ana Nicolaci da Costa
LONDON, Oct 2 (Reuters) - Euro zone money markets have shown tentative signs of recovery in recent weeks along with improving appetite for risk in the region, but even the optimists say the crisis will have to be past before interbank lending is back to normal.
Some analysts say a pick-up in volumes in overnight lending, a fall in the amount banks borrow from the European Central Bank and debt issuance by Spanish banks are indicative of a thawing of money markets, but traders say the interbank markets remain frozen.
A sharp narrowing of the gap between three-month interbank lending rates and overnight rates to pre-U.S. crisis levels further shows the start of some return to normality, they say.
"(The spread) is trading at very tight levels. That is the best indicator that the stress in the interbank market is coming down," Alessandro Giansanti, rates strategist at ING said.
The difference between three-month Euribor and overnight Eonia rates - a key measure of counterparty risk - last week fell to 11 basis points, its lowest since mid-2007, and was trading around that level on Tuesday.
Appetite for riskier assets has increased since late July when ECB President Mario Draghi first hinted at a plan to buy sovereign bonds, saying the central bank would do what was necessary to preserve the euro.
The change in sentiment as well as technical factors have helped to narrow the Euribor/OIS spread.
The deposit rate - which serves as a floor to the overnight lending rate - was cut to zero on July 5. Euribor rates have continued to trend down since then on expectations of further monetary easing.
Traders say, however, that the reduction in funding risk has so far not translated into greater lending between banks.
"The stimulus that has been provided has been great in putting out the fire of the credit situation ... what we now have is a situation where the vast majority of banks are awash with cash," a money market trader said.
"The banks don't need to borrow. They've got loads so the bid just keeps on going lower and lower," he added.
Daily average Eonia volumes for September were 26.3 billion euros, compared with 20.9 billion euros in August and 23.7 billion euros in July, according to Reuters data.
That rise, along with a 32 billion euro decline in aggregate borrowing by banks from the ECB since the end of August , shows an improvement in market sentiment, Barclays said in a research note.
Analysts also interpreted Spanish banks' recent issuance of debt as a positive sign, given that the country's corporate bond market has been frozen for months. .
BBVA , Spain's second-largest bank, sold 1.5 billion euros of a three-year bond in September, following an issue by peer Santander .
"There is clearly a long way to go for markets to normalize ... but it is nevertheless an encouraging sign," Barclays said.
Some analysts say banks are still worried about each other's exposures to European sovereign debt markets.
Twenty-three of 24 traders in a Reuters poll published on Monday said they have not seen any improvement in interbank lending in the currency bloc since July, when the central bank made its promise. .
For banks to be willing to lend normally again, the crisis would have to be close to being resolved, analysts say.
"As long as there is a risk that there will be a pick-up in the crisis, it's not over yet, even if the central bank is supporting the financing needs," Giansanti added.
(editing by Jane Baird)
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Keywords: MARKETS MONEY/