NEW YORK, April 7 (Reuters) - A prolonged war in the Middle East is starting to ripple into U.S. short-term credit markets, where subtle strains are emerging that could amplify liquidity risks.

Short-term credit spreads have widened in the last few weeks, reflecting jitters about the prospect of a protracted conflict that has led to a generally risk-averse environment.

Iran showed no sign of accepting U.S. President Donald Trump's ultimatum to open the Strait of Hormuz by 8 p.m. EDT on Tuesday, unsettling many investors who are eager for the conflict to end. Trump on Tuesday doubled down on his threat to launch aggressive strikes in Iran, saying "a whole civilization will die tonight" unless Tehran reached a last-minute deal.

Analysts are pointing to the beginnings of tension in the roughly $1.5 trillion U.S. commercial paper (CP) market - a critical short-term funding source for corporations and banks. It's a key barometer of funding or credit problems.

The market initially brushed off the conflict in the Middle East, but concern has mounted as it has dragged on.

"Credit generally has widened across the entire curve and pretty much broadly across industries," said Jan Nevruzi, U.S. rates strategist at TD Securities in New York.

"The entire curve just got priced higher. So you have to pay a little bit more for funding."

Some pressure is also starting to build in the $2 trillion U.S. bank floating rate note (FRN) market. It's a sector that is often underappreciated because it sits between the front-end funding space - where CPs and certificates of deposit are predominant - and the longer-dated corporate bond market.

WIDER CP SPREADS

The spread between 30-day rates on AA-rated non-financial CP over the one-month Secured Overnight Funding Rate (SOFR), which is backed by Treasuries, widened to 6 basis points, the Federal Reserve's latest weekly data showed. Before the start of the Iran war on February 28, that spread stood at zero.

This gap measures the extra compensation investors demand to lend to high-quality corporates instead of lending against Treasuries. A widening spread signals that unsecured funding, in this case AA non-financial issuers, is becoming more expensive relative to secured funding, which is an early sign of worsening credit conditions.

Similar strains are emerging among lower-rated borrowers. The spread for 30-day rates of A2/P2 non-financial issuers over SOFR increased to 44 bps, compared with just 17 bps before the start of the conflict.

"It's costing (commercial paper) issuers a little bit more to fund their books," said Teresa Ho, head of U.S. short-duration strategy at J.P. Morgan in Boston.

On the investor side, she said CP buyers are holding back for now, waiting for clearer signs of stability before re-entering the market. The prevailing uncertainty has made them cautious, she noted, because "we don't know how liquidity is going to look over the next few weeks."

Prime money market funds, which are among the largest CP buyers, have seen their assets fluctuate over the last few weeks. Their assets fell 2% in the week ending April 1 to $1.246 trillion, the latest data from the Investment Company Institute showed.

Analysts said a decline in money market fund assets likely means they're allowing short-term holdings like CPs to mature instead of rolling them over, with the proceeds possibly used to meet redemptions if there are any.

LOWER-TIER CREDIT FIRST TO CRACK

Market participants are also watching the spread between the lower quality A2/P2 credit and those of top-rated A1/P1 issuers. In general, A2/P2 trades at a modest spread premium to A1/P1, compensating investors for the incremental downgrade or default risk.

A2/P2 is often the first segment of the CP market to crack during crises. In times of heightened uncertainty, money market funds typically pull back from lower-rated issuers, demanding higher yields for their credits and widening their spread over the higher-rated A1/P1 issues.

The latest Fed data showed that the spread between 30-day A2/P2 credit and the same tenor for an A1/P1 issue was 38 basis points, a level analysts characterize as consistent with a mild risk-off environment. Before the war, it was at 20 bps. The spread was at 200-300 bps in March 2020, at the outset of the COVID-19 pandemic.

Signs of caution are also surfacing in the bank FRN market, J.P. Morgan's Ho said, with the six-month bank FRN spread over overnight SOFR widening by about 13 bps to 33 bps in March.

FRNs are a key source of term unsecured funding issued largely by the biggest U.S. banks and carrying longer maturities than commercial paper. Because they anchor banks' funding costs, widening FRN spreads are widely viewed as a signal of tightening credit conditions.

"The general corporate financing story is all about people becoming more cautious about counterparty credit and credit exposures," said Joseph Abate, head of rates strategy at SMBC Nikko Securities in New York.