European shares hit a new five-month high on Thursday as a successful Spanish bond auction in which the country sold more than double its target and cut borrowing costs helped in improving sentiment and boosted cyclical sectors such as banks.

Investors awaited an Italian bond auction on Friday, which could push share prices higher if it, too, proved successful, analysts said. Thursday's next focus was on European Central Bank President Mario Draghi's news conference, starting at 1:30 p.m., after the central bank kept rates at 1 percent. The Bank of England also left its key interest rate unchanged, at a record low of 0.5 percent.

Markets are looking for any sign the ECB could steer rates into uncharted territory in coming months - most analysts expect a cut in February or March - or whether it is happy to leave them as the economy is showing some tentative signs of life.

Banks, many of which are highly exposed to peripheral euro zone countries, were the top gainers on hopes an improvement in the region's debt situation could accelerate the pace of economic recovery and repair their balance sheets.

The STOXX Europe 600 Banking index <.SX7P>, the worst-performing sector last year with a fall of 32 percent, advanced 3.5 percent, while the FTSEurofirst 300 <.FTEU3> index of top European shares was up 0.8 percent at 1,030.10 points at 12:51 p.m. after touching 1,031.08 -- the highest since early August.

The Spanish auction has allowed the euro to rally which has also assisted in the strength of the equity markets. So far the start to 2012 has been a positive one and even though there are significant headwinds, there are still many people out there who believe equities are undervalued, said Angus Campbell, head of sales at Capital Spreads.

According to Thomson Reuters Datastream, stocks on the STOXX Europe 600 index <.STOXX> traded at 9.9 times their one-year forward earnings, against a 10-year average of 12.9.

Spain's first auction of 2012 was seen as a test of confidence in Europe's ability to meet its funding needs. Its borrowing costs fell, but it still faces challenges this year to meet tough European deficit targets after the government missed its 2011 cost-cutting goal and the economy sinks into recession.

The Spanish auction washes away some of the pessimism, Peter Dixon, economist at Commerzbank, said. If we get a decent Italian auction, then there is every chance that over the course of the next few months, we see some positive sentiment and a little less volatility.

MINERS IN DEMAND

Miners also gained ground, helped by a rally in key base metals prices on hopes of an improvement in demand for metals and as a weaker dollar made metals cheaper for buyers having other currencies.

The STOXX Europe 600 Basic Resources index <.SXPP>, which fell 30 percent last year to become the second biggest decliner,

rose 2.3 percent.

But some analysts advised caution in aggressively buying cyclical stocks saying that the euro zone debt crisis remained unresolved and the pace of global economic recovery stayed fragile.

I still think that you want to avoid cyclical stocks for the first few months of the year at the very least. It's a question now of ensuring that we preserve our capital rather than we make a big return on it, Dixon of Commerzbank said.

Among decliners, retailers <.SXRP> suffered heavily, down 4.9 percent, as Tesco issued a profit warning after reporting its worst Christmas sales performance for decades. Its shares fell 14.4 percent.

This raises concerns for long term growth as, ultimately, if the UK's profits keep falling, then it (Tesco) will not be able to invest as much overseas, so long term growth will slow and returns will significantly undershoot targets, Philip Dorgan, analyst at Panmure Gordon, said.

The world's third-biggest retailer's warning was accompanied by a raft of weak trading updates from British store groups including Home Retail-owned Argos . Its shares fell 4.8 percent.

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ECB in graphics http://link.reuters.com/neg32s

Euro zone debt crisis in graphics http://r.reuters.com/hyb65p

Euro zone bank funding strains http://link.reuters.com/rer25s

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(Graphics by Vincent Flasseur; Editing by Jon Loades-Carter)