Kenya's interbank lending rate tumbled to 19.2515 percent on Tuesday from 27.7299 percent the previous day, central bank data showed on Thursday, as the bank's action last week to bring down interbank rates filters through the market.

Kenyan stocks hit a fresh 20-month low due to a weaker currency, high inflation and political concerns. The shilling slipped a third of a percent versus the dollar on the back of importer demand for the U.S. currency.

Analysts said the shilling's prospects hinged on sustained action by the central bank aimed at ensuring that banks do not tap the discount window to lend to others.

It is the tightening of liquidity, by ensuring that the discount rate is always higher than the interbank rate... that will subdue the weakening pressures on the shilling, said Yvonne Mhango, sub Sahara Africa economist at Renaissance Capital.

The central bank's discount window lending rate fell again to 17.87 percent on Thursday from 20.17 percent on Tuesday, the bank said on its website. Wednesday was a public holiday.

The discount window rate has plummeted from 31.4 percent late last week, when the central bank changed the way it calculates the rate in order to ease a liquidity crunch.

Commercial banks borrowed 1.09 billion shillings through the discount window on Tuesday, according to the central bank's money market report, against 1.1 billion on Monday.

However, fund demand in the market increased, which suggested money market conditions might be normalising and that interbank rates could soon stabilise.

Traders predicted interbank rates would hover between 15 and 20 percent in coming days. That would be just above the August inflation rate of 16.67 percent.

Analysts said the central bank had cooled sky-high money market rates with its policy adjustment but still faced a struggle to restore market confidence after the wide swings in policy and to stem the weakness of the shilling.

It took extraordinarily high interbank rates and a significant shortage of market liquidity to exert any influence on the shilling. Even that was untested over the longer term. Confidence is key to the shilling's prospects at the moment, said Razia Khan, head of Africa research for Standard Chartered in London.

STOCKS SLIDE

On the Nairobi Stock Exchange, the benchmark NSE-20 Share Index tumbled 1.81 percent to 3,402.13 points, touching a fresh 20-month low, and all but one of its constituent stocks fell.

Faith Atiti, an analyst at Sterling Investment Bank, blamed the fall to the rising inflation rate -- at 16.67 percent in August -- a weakening shilling and political jitters due to the on-going post-election violence hearing at the International Criminal Court (ICC).

If things continue the way they are, we're expecting the government to even downgrade its growth forecast. There is no positive news coming in to support this market, Atiti said.

SHILLING

Traders said they did not expect lower interbank lending rates to cause a big drop in the currency, at least for now.

The shilling closed 93.90/94.00 to the dollar, down from Tuesday's close of 93.65/75. Traders predicted the shilling would trade in tight band of 93.75-94.25 range in the days ahead.

It is the traditional end of the month demand from the energy sector, said Dickson Magecha, trader at Standard Chartered Bank.

The change in the formula for calculating the discount window rate came after Treasury officials, worried by the impact of soaring interbank rates on growth and the government's own funding schedule, intervened and Finance Minister Uhuru Kenyatta called for monetary stability.

In the bond market, traded volumes rose to 2.53 billion shillings from 1.42 billion on Wednesday, and fixed-income traders predicted that the liquidity situation will have a mixed impact on the curve.

Short end bond yields will drop, but long end bond yields will remain flat. Treasury bill yields will be under pressure because of huge rollovers, said Alexander Muiruri, fixed income trader at African Alliance.

An unusually large amount of Treasury bills and bonds worth around 47 billion shillings are expected to mature this month.