GRAPHIC-European bank stocks on top in October as yield spike spurs sector rotation

* European banks best performers in Oct (HKSE: 3366-OL.HK - news) : http://reut.rs/2f4tb2x

* Bank shares vs sov bond yields: http://reut.rs/2f4ukqM

* Sector index poised for best month since Feb 2015

* No longer 2016 biggest sectoral faller, though issues remain

By Alistair Smout

LONDON, Oct 31 (Reuters) - European bank stocks are poised to end October posting their best monthly gains since February last year as cheap valuations, strong results and prospects of higher bond yields spurred investor interest in the beaten-down sector.

Banks are Europe's best performing sector this month with a 9 percent gain, handily beating the broader market's 1 percent decline.

This month's rally stands in contrast to the prevailing mood on banks at the end of September, when shares of Deutsche Bank (LSE: 0H7D.L - news) fell to an all-time low on the back of fears of a $14 billion fine from U.S. authorities while fears over bad debts clouded the outlook for Italian banks.

Those fears added to long-standing worries over banks' profitability given a weak regional economy, the potential fallout of Britain's vote to leave the European Union and as the slide to record lows for bond yields weighed on margins.

After losing more than a quarter of their value in the year to end-September and with valuations near euro zone crisis lows of about 0.6 times book value, however, some investors questioned whether the selloff was overdone.

A pick up in bond yields, broker optimism and a relatively healthy set of third-quarter results, which included a surprise profit at Deutsche Bank, has brightened the case for financials.

"Banks remain the best hedge against rising yields," strategists at JP Morgan said in a note, recommending switching in to cheaply valued financials from expensive areas such as consumer staples and tech.

European banks best performers in Oct: http://reut.rs/2f4tb2x Bank shares vs sovereign bond yields: http://reut.rs/2f4ukqM

Along with JPMorgan (LSE: JPIU.L - news) , strategists from Citi and Bank of America Merrill Lynch switched to more bullish views on the sector with the former calling European banks "the world's biggest contrarian trade".

Deutsche Bank shares are up nearly a third since their lows while the likes of Barclays (LSE: BARC.L - news) , BNP Paribas (LSE: 0HB5.L - news) and Santander all got boosts from their results.

Despite the rally, concerns over regulation of the sector, the effects of Britain's departure from the European Union and anaemic growth in Europe remain. The sector is still down 16 percent this year and down 33 percent from a July 2015 high.

The rebound in bank shares comes as investors have taken some profits in richly valued, defensive sectors such as healthcare, utilities and telecoms whose dividends become less attractive as bond yields rise.

October's rally lifted banks above telecoms as Europe's worst performing sector so far this year.

(Editing by Alison Williams)