Hedge funds are cranking up their bets in equities and credit in 2012's buoyant markets in the belief that the euro zone, U.S. and Chinese economies will fare better than many were fearing last year.

Many funds think the European Central Bank's long-term refinancing operations (LTRO), which flooded markets with 489 billion euros ($644 billion) of cheap cash in December and provide more this month, are a turning point in propping up the region's battered banks.

They are also betting that China, which is facing a fifth successive quarter of slowing economic growth, will experience a so-called 'soft landing', while the U.S., which saw its fastest growth in one-and-a-half years in the fourth quarter, is firmly on the recovery path.

The average hedge fund rose 2.6 percent in January but this was behind the S&P's <.SPX> 4.5 percent gain, according to Hedge Fund Research, and some funds missed out on the rally after taking a cautious stance towards the end of a turbulent 2011.

Many managers are now hiking borrowing to make their favorite bets punchier, or shifting the balance between their long and shorts to help them profit from market gains.

What we're hearing from a number of managers is that the appetite for risk has risen, said Frank Frecentese, global head of hedge fund investments at Citi Private Bank.

Their view on Europe is that the possibility of an extreme left-tail event has lessened, the U.S. is doing moderately better than expected and the risk of China ... heading for a hard landing has lessened.

The FTSEurofirst 300 <.FTEU3> of top European shares is up 8.3 percent so far this year.

One London-based hedge fund manager told Reuters he had cut his gross long equity position to around 80 percent by the end of last year.

However, in early January he raised this to 120 percent and plans to take it up to a long-term average of 130 percent in the next few weeks.

POSITIVE CASE

Managers, who lost 5.2 percent on average last year after many mistimed their bets, are now using a range of means to increase their bets.

Some funds are snapping up derivatives, which have fallen in price as volatility has slumped this year, as a cheap way of hedging their portfolios.

Tail hedges have gotten a lot cheaper, so some managers are willing to increase exposure to their best ideas and they can buy protection at a reasonable price in case things go wrong, said Citi Private Bank's Frecentese.

London-based hedge fund firm LNG Capital is upbeat on banks because of the LTRO and has increased its fund's net position from between 25 and minus 25 percent in the second half of last year to between 50 and 60 percent net long.

Partner and senior portfolio manager Steven Mitra told Reuters he has been looking at the subordinated part of the capital structure for non-peripheral banks and lower tier two callable bonds, where there has been or will be a tender at a premium to the current price.

We've seen the ECB flood the banks with cheap capital, so the whole (threat) of the financial system collapsing has been negated for the time being or pushed back, said Mitra.

We like the banks sector and continue to believe, in the absence of a disorderly default and contagion due to Greece, that there is a very positive case for this sector.

He added that, thanks to the extra liquidity, any further haircuts the banks have to take on peripheral European bonds would hurt but the sector would not collapse.

PROCESS OF HEALING

However, even those less positive on the banking sector or the euro zone's debt difficulties still see reason to take punchier bets.

Sal Naro, founder of Coherence Capital Partners, which trades credit, is using relative value trades to express his view of a sustained, moderate recovery in the U.S., while Europe is in a very, very difficult period.

I do think now is the time to increase risk. I wouldn't have said that in '08 or early '09. Overall we're in a process of healing, he said.

Our view is more skewed to longs on U.S. companies and shorts on European ones ... There's some good upside relative value momentum (in sectors we like) and some downside momentum (in sectors we don't like).

He favors sectors such as autos and commodities, and is negative on financials and pharmaceuticals.

(Car) inventories need to be replaced, the average age of cars has risen to approximately 10 years and advantageous funding is available, he said. We're negative on financials, which still have a way to go in cleaning themselves up.

Copper and oil... (are) sectors to be reckoned with as the world moves towards global growth and will start to perform again. We're nervous on healthcare, particularly with U.S. elections, which could be a significant drag. You need to do your homework there. ($1 = 0.7597 euros)

(Reporting by Laurence Fletcher; Editing by Helen Massy-Beresford)

China Citigroup