LONDON (Reuters) - European shares closed higher on Thursday, boosted by euro zone banks as newly available cheap cash from the European Central Bank helped some sovereign bond yields to fall and further allayed default risks among corporates.
Euro zone banks .SX7E rose 2.6 percent after France's and Spain's borrowing costs fell at auctions on Thursday and yields on Italian notes dropped on the secondary market.
Italian banks, which own the lion's share of the country's debt, led gainers with Banco Popolare BAPO.MI rising 10.5 percent and UniCredit (CRDI.MI) up 5.8 percent, helping Milan's FTSE MIB index outpace its peers to close 2.9 percent higher.
Italian lenders took a quarter of all the money available at the ECB auction on Wednesday, a source said, fuelling trader speculation they would continue buying Italian debt, possibly moving on to longer maturities such as three- and five-year notes in order to record larger profit from carry trades.
"The funding risk in the banking system has reduced substantially," Dennis Jose, strategist at Barclays Capital, said.
Jose, however, remained cautious on the prospect of a sharp equity re-rating fuelled by ECB money and reiterated his 675 points year-end target for the pan-European Stoxx 600 index, pointing to a mere 3 percent upside to Thursday's close at 267.06.
"The LTRO could be just one of the individual pieces required to form the re-rating puzzle," Jose said.
"If we have further confirmation that the European economy is not heading towards a severe recession and the U.S. economy is stable, then we could actually start to witness a re-rating in the equity market."
But prospects for a sustained global economic recovery darkened on Thursday as sputtering factory activity in Europe overshadowed more upbeat data from Asia and mixed readings in the United States.
European Union leaders met on Thursday to try to find a balance between budget austerity and reviving lost growth, focusing on structural economic reforms and other ways to combat record unemployment.
The FTSEurofirst 300 .FTEU3 index of pan-European shares ended 1.1 percent higher at 1,086.72 points on Thursday, a level not seen since February 22.
Volume on the index, however, was in line with its lackluster 90-day average, suggesting investors were still reluctant to go back into equities.
Among the most heavily traded stocks was French telecoms and entertainment group Vivendi (VIV.PA), which fell 10.1 percent on volume more than six times its average after a steeper-than-expected dividend cut.
"The dividend market was primed at 1.4 euros a share for this year and 1.25 for next year, so the news surprised the market a little bit and that's why the share reaction has been so severe," a head of derivatives trading at a European investment bank said.
"As a result, the forward dividend market has fallen quite a lot, by around 30 percent, and the 2013 dividend is now trading at less than 1 euro."
Asset returns in 2012:
Euro zone debt crisis in graphics:
Volatility on euro zone shares, a measure of equity investor 'fear' gauged by the Euro Stoxx Volatility index .V2TX, fell 4.5 percent on Thursday but analysts warned spikes were possible in the coming months.
The gauge, based on sell- and buy-options on the Euro STOXX 50 .STOXX50E index, is down more than 40 percent since the start of December, as a steady flow of ECB cash supported equities and eased investor concerns about future share price declines.
"Implied volatilities have declined sharply across asset classes, as markets have been buoyed by the tidal wave of liquidity introduced by the ECB's LTRO program," Deutsche Bank said in a note.
"But albeit low in absolute terms, they are at the same time very expensive as realised vols (volatilities) are even lower."
While suggesting implied volatility could fall even further, Deutsche Bank warned sharp rises were likely, in a market characterised by moves from "large volatility spikes, into deep volatility lulls".
Corrects ticker symbol of UniCredit in paragraph 3