By Marc Jones
LONDON (Reuters) - European shares reached a new 5-1/2 year high on Friday as a third weekly gain on the spin for Portuguese and Spanish bonds fed improving sentiment in the region's Mediterranean rim.
Disappointing results from some of Wall Street's big names on Thursday had dampened investors' mood overnight but Europe's ongoing recovery and hopes U.S. data later will paint a brighter picture put a spring back in their step.
Future's prices pointed to gains of around 0.3 percent for the major U.S. indexes when trading resumes in New York, while the dollar index (.DXY), which tracks the greenback against a basket of six major currencies, was already pushing higher.
After another week of steady progress, European shares (.FTEU3) were on the up again as they climbed 0.5 percent.
London's FTSE (.FTSE), Paris's CAC 40 (.FCHI) and Frankfurt's Dax (.GDAXI) all made gains and bourses in Portugal, Italy (.FTMIB) and Spain (.IBEX) continued their red hot streak to leave the region heading for its fourth week of gains in five.
"Investors are willing to take more risk and in the periphery we have seen quite a lot of good developments," said Rabobank euro zone economist Emile Cardon.
"I think economic growth in most European countries will continue to rise ... Portugal saw a lot of demand when it went to the capital markets and we have seen quite good progress in Ireland, so most of these developments are supportive."
After a brief early breather, euro zone bond markets also continued their rally as Portuguese and Spanish government bonds added to a third week of strong gains.
Portuguese yields were nestled at 3-1/2 year lows at just over 5 percent after Standard & Poor's removed the immediate threat of a downgrade to Lisbon's rating on Friday. The country's borrowing costs are now down a full percentage point since the end of last year.
"It was not that long ago that we were almost certain that Portugal would still need another program," said Marius Daheim, chief strategist at Bayerische Landesbank.
Applying some pressure on the bond market rally was a third spike in as many months in overnight euro money market rates, which left them above the normal ceiling of the European Central Bank's main 0.25 percent borrowing rate.
The move up has been driven by a sharp drop in the amount of spare cash sloshing around the euro zone banking system. Banks have paid back almost half the 1 trillion euros the ECB pumped into markets at the height of the euro crisis.
Rising money market rates are one of the factors Mario Draghi has underlined as a potential trigger for the ECB to cut interest rates again or take even more drastic action.
There were signs of self-regulation of their ECB borrowing by banks on Friday but it provided little respite for the euro as it struggled against the strong dollar.
Sterling, in contrast, surged half a percent to $1.6440 after UK retail figures came in far stronger than forecast, wrongfooting many traders who have turned more bearish on the pound after its strong run over the last six-months.
"We were contemplating a test of support for the pound at $1.6320. In the end we got this stonking number which provoked a genuine reaction," said Daragh Maher, strategist with HSBC in London.
Some of Thursday's gloom was cleared ahead of the Wall Street restart as global giant General Electric (NYSE:GE - News) posted a rise in profits, though costly legal bills hit bank Morgan Stanley (NYSE:MS - News)
A batch of U.S. data due later will include December U.S. housing starts, building permits, industrial production and the University of Michigan sentiment index, all of which investors will be hoping will paint a brighter picture.
U.S. crude oil futures rose 0.5 percent to $94.50 a barrel, not far from a two-week peak of $94.64 reached earlier this week after U.S. government data showed a larger-than-expected drop in inventories. They were set to post their first weekly gain in three weeks.
Gold was steady at $1,242 an ounce. However, it was nickel that caught the eye: despite a dip on the day, Indonesia's recent ban on ore exports left the metal heading for its biggest weekly rise in almost a year.
(Additional reporting by Ian Chua in Sydney, Marius Zaharia and Patrick Graham in London; Editing by Alison Williams and Susan Fenton)