Italian banks help euro zone shares touch 5-1/2 yr peak

* FTSEurofirst 300 up for 5th straight session, rises 0.1 pct

* Euro STOXX 50 index briefly hits 5-1/2-year high

* Italian banks rally on Popolare, Monte Paschi boost (Updates at settle, adds volume, Fed)

By Francesco Canepa

LONDON, March 31 (Reuters) - Milan-listed shares outperformed skittish European bourses on Monday, helping a euro zone index touch a 5-1/2 year peak as the market welcomed signs that smaller Italian lenders are boosting their capital and winning over international investors.

Broader sentiment was also supported by expectations of new stimulus measures from the European Central Bank, cemented by lower-than-forecast euro zone inflation data, although some portfolio rebalancing at the end of the first quarter triggered a late selloff.

Italian mid-tier banks Banco Popolare (Dusseldorf: B8Z.DU - news) and Monte Paschi (Milan: BMPS.MI - news) were among top risers on the STOXX Europe 600 index, up 15.8 percent and 4.9 percent respectively, compared with a 0.2 percent rise for the whole index.

Banco Popolare was boosted by reports that it had attracted foreign investors to its capital increase, while Monte Paschi saw two big Latin American funds take stakes ahead of the bank's own cash call, a sign of growing confidence in the sector and in the Italian economy from international investors.

"This round of capital increases is seen as a reinforcing element for banks in the context of a more stable economic environment," said Roberto Brasca, who manages a pan-European equity fund for AcomeA and is overweight smaller Italian lenders.

"Once these banks have sorted themselves out in terms of capital ratios, they can use their resources to lend."

A raft of price target upgrades by investment banks boosted Italian lender Intesa Sanpaolo (Frankfurt: IES.F - news) , which added 2.4 percent to feature among top risers on the Euro STOXX 50 index index.

The euro zone blue chip index hit its highest level since 2008 at 3,185.68 points before succumbing to some quarter-end profit taking to end 0.3 percent lower at 3,161.60 points. The pan-European FTSEurofirst 300 index rose 0.1 percent to 1,333.55 points, taking its quarterly gains to 1.3 percent.

Italy's FTSE MIB, up 0.9 percent on Monday, has outperformed both indexes so far this year as Italy emerges from a deep two-year recession and the new government of Prime Minister Matteo Renzi raises expectations of long-awaited economic and political reforms.

Credit Suisse (NYSE: CS - news) strategists expect further gains in Italian stocks, saying the reforms should boost the economic recovery. It noted credit conditions were easing and the shares' valuations were still the cheapest in Europe.

STIMULUS FOCUS

Elsewhere, investors remained cautious on the last day of the quarter and ahead of the European Central Bank's policy meeting on Thursday and U.S. jobs data on Friday.

Data on Monday showed inflation in the euro zone fell to its lowest level since 2009, fuelling speculation the ECB may sooner or later take radical action such as the launch of quantitative easing (QE) to tackle the threat of deflation.

"(The) chances of an additional rate cut and potentially QE after that have clearly increased," said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets in Brussels.

"This should be longer-term positive for European equities. Today the end of quarter rebalancing is potentially clouding this trend."

Federal Reserve Chair Janet Yellen gave a strong defence of the U.S. central bank's own stimulus policy on Monday, saying its "extraordinary" commitment to boosting the economy, especially the still struggling labour market, will be needed for some time to come.

Quarter-end portfolio rebalancing boosted trading activity, with volume on the STOXX 600 Europe index 40 percent higher than the index's three-month average.

Europe bourses in 2014: http://link.reuters.com/pap87v

Asset performance in 2014: http://link.reuters.com/gap87v

Today's European research round-up (Additional reporting by Atul Prakash in London and Blaise Robinson (LSE: RBN.L - news) in Paris; Editing by Alison Williams)