By Mike Bird and Max Colchester

Last week, Credit Suisse Group AG's Chief Executive Tidjane Thiam stood up to deliver what seemed like bad news: the Swiss lender would miss some profit targets and cut yet more costs.

The bank's shares soared 7%.

After being pounded for months, Europe's beleaguered banking sector is back in vogue. Spurred by the prospect of looser regulations and higher interest rates, investors are piling back into the sector. The Stoxx Europe 600 Banks index is less than 1% below its level at the start of 2016, a huge reversal for a sector that spent the year as one of the region's worst performers.

On Wednesday, the Federal Reserve gave the sector a further boost when it raised interest rates and hinted at further increases next year. That pushed the European bank share index up 1.6% on Thursday.

Some strategists believe there are further returns to come.

European bank stocks had become too cheap, Ian Butler, a fund manager with J.P. Morgan's Europe Strategic Value Fund, said.

"If you look at the valuation, they were close to 2012 levels, but the environment now is very different," he said.

The banks' share prices are still well below their mid-2015 levels, let alone their pre-financial crisis highs.

These banks may have found a savior in Donald Trump. Investors have bet that the U.S. president-elect will embark on an infrastructure-spending binge that will send ripples across the European economy--eventually prompting the region's central banks to raise rates. Loosening regulations, another of Mr. Trump's pledges, will also help European banks, investors say.

Rising interest rates make banks' basic lending business more profitable. An increase in yields on longer-term debt in global markets has already boosted financial stocks. On Thursday, bond yields were higher across the board.

More buoyant banks are key for the eurozone's economy, where extremely weak lending to businesses has held back the recovery

Goldman Sachs upgraded European banks to overweight in their asset allocation for 2017, meaning they aim to hold a larger share of them than a benchmark portfolio would suggest.

"We are ending our two-year cautious European Banks stance," J.P. Morgan analysts wrote to investors on Monday.

Bank of America Merrill Lynch's December fund manager survey showed allocations to bank stocks surging to record highs, with a net 31% of fund managers overweight on the sector's stocks.

At the start of 2016, investors all but threw in the towel on the European banking sector. Stocks dropped to 2008 crisis-era lows as investors braced themselves for years of litigation problems, ultra-low interest rates and grinding restructuring plans.

Shares of Deutsche Bank AG slumped to levels not seen since the 1980s as fears mounted that it would struggle to pay a multi-billion dollar settlement with U.S. authorities over the sale of mortgage-backed securities.

Italian bank valuations plummeted amid worries that several small lenders with balance sheets packed with souring loans would keel over, creating a domino effect. The Brexit vote triggered a massive selloff in U.K. bank shares on predictions that the City of London would lose its passport to continental Europe and the British economy would soon head into meltdown.

Many European banks still face huge structural issues, but these doomsday predictions have yet to come true.

While the European Central Bank isn't rushing to hike rates, the end of ever-easier monetary policy could benefit financial stocks.

"Rates certainly seem like they're not going to fall from here," Mr. Butler said. And the prospect of rate rises and the accompanying volatility bode well for investment banks as clients head back into the market to trade and buy protection against swings in the value of assets.

Deutsche Bank and Barclays PLC, which both have big investment banks, have seen shares rally over 30% in the last three months.

Credit Suisse's shares are up as investors cheered the bank's progress on cutting costs.

Meanwhile, banks have thickened their capital buffers, making them more resilient to financial shocks. Banks could also benefit from softer incoming regulations.

New global rules dubbed "Basel IV" are being hashed out and bankers in Europe initially feared that U.S. regulators would successfully urge tighter restrictions on how lenders calculate the riskiness of their own assets. Now thanks to Mr. Trump's pledges to cut regulations and a concerted push by European politicians, investors think less pain will be inflicted than originally feared.

European banks aren't in the clear yet. Bank profits in Europe are set to drop to $77 billion in 2020 from $110 billion, as they wrestle with low economic growth and painful cost cuts, according to consultancy McKinsey & Co.

There are plenty of political risks on the horizon in 2017, with elections in France, Italy, Germany and the Netherlands. These votes could give greater power to populist parties that analysts believe could hurt economic growth--and in France and the Netherlands, challenge their countries' membership of the euro.

Brexit negotiations are also due to start by March 2017, potentially forcing some banks into expensive restructuring as the U.K. breaks away from the European Union.Some are skeptical about the bank rally. "I don't think it's warranted," David Hendler, founder at Viola Risk Advisors, a bank consultancy, said. "What does European banking have to offer the rest of the world? Not a lot."

Write to Mike Bird at Mike.Bird@wsj.com and Max Colchester at max.colchester@wsj.com

(END) Dow Jones Newswires

December 15, 2016 09:52 ET (14:52 GMT)

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