The monthly flow of loans to firms stabilized in January, declining by just 1 billion euros after falling 35 billion euros in December - the fastest drop on record - ECB data showed on Monday.

The flow of loans to households turned positive and the figures showed some of the cash flowed into peripheral euro zone government bonds, which have seen yields fall markedly.

The money supply data had been eagerly awaited as they gave a glimpse of how bank lending activity responded to the ECB's first 3-year funding operation - or LTRO - late last year, which flooded the financial system with 489 billion euros of ultra-cheap cash.

"The positive psychological impact on markets and, particularly, government bond markets has been obvious from the start," ING economist Carsten Brzeski said of the ECB operation.

"The economic impact, however, remains still limited. As a consequence, this week's second 3-year LTRO is clearly not redundant," he said.

ECB President Mario Draghi has said the bank's move avoided a "major, major credit crunch," comments that Monday's data support. The central bank will offer banks the chance to grab another tranche of the ultra-cheap, 3-year money on Wednesday.

The median expectation in a Reuters poll of 60 economists showed that the ECB will allot 492 billion euros ($647.6 billion) at 1 percent. Forecasts ranged from 200 billion to 1 trillion euros.

It remains to be seen whether the second injection of ECB 3-year loans will open up lending channels to companies again.

So far, banks have used most of the cash they took in the ECB's first dose of funds to plug holes in their own balance sheets and to buy government bonds, which has helped bring down Spain's and Italy's borrowing costs.

The ECB data showed that Spanish as well as Italian banks increased their monthly net purchases of government bonds by record amounts in January.

Spanish banks increased their holdings of securities issued by euro zone governments by a record 23.1 billion euros, bringing the total they held in January to 229.6 billion.

The data do not break down banks' holdings by issuing country but the presumption is that they focused on domestic debt.

In Italy, the monthly rise in the value of government debt holdings was 20.6 billion euros month, also a record monthly increase, increasing the total to 280 billion euros.

Italy's six-month borrowing costs sank towards 1 percent at auction on Monday as it sold 12.25 billion euros in short-term bills, meeting solid demand ahead of the latest ECB cash offer.

"I suspect this is market positioning in anticipation of a relatively significant LTRO take-up, the proceeds of which will then be parked in the front end of the Italian curve," said Rabobank strategist Richard McGuire.

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For a graphic on euro zone money supply and loans, click:

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MODEST EXPANSION

Overall money growth in the currency bloc also pointed to slow a recovery in the tight credit conditions at the end of last year, which led the ECB to embark on the 3-year funding operations.

Euro zone M3 money supply - a more general measure of cash in the economy - grew at an annual 2.5 percent in January, picking up from 1.5 percent in December and smashing expectations of analysts polled by Reuters of a 1.8 percent increase.

The three-month moving average of M3 growth was flat at 2.0 percent, remaining well below the ECB's reference rate of 4.5 percent, above which the bank sees dangers to medium-term price stability.

"This shows that we are avoiding an outright contraction in money growth, but these are still very weak levels indicating modest expansion of credit in the euro zone, and that's fully in line with what we'd expect after the severe credit crunch at the end of last year," said Andres Matzen, analyst at Nordea.

(Reporting By Eva Kuehnen, editing by Mike Peacock)

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