(Reuters) European stocks rallied and the euro was well bid Wednesday as investors priced in an improvement in the economic outlook and looked forward to a big take up by banks of the European Central Bank's first-ever offer of three-year loans.

Stocks and commodities began an end of year rally Tuesday when German data encouraged hopes Europe's largest economy would avoid a recession. This was followed by better-than-expected U.S. housing data and new Federal Reserve capital proposals for banks, which turned out to be less onerous than some had feared.

The ECB will offer banks unlimited amounts of low-cost, three-year funds against collateral now more broadly defined, which many analysts hope will encourage buying of high-yielding Spanish and Italian bonds, helping ease the crisis in the euro bloc.

A significant uptake is all but guaranteed and that's something that could continue this 'risk-on' (mood), said Robert Rennie, chief currency strategist at Westpac in Sydney.

The FTSEurofirst 300 <.FTEU3> index of leading shares rose 0.7 percent in early trading, but is still down some 13 percent in 2011, as the euro zone debt crisis and worries about a recession have taken their toll.

The euro stood at $1.312, up 0.3 percent after rising to an Asian session high of $1.31278 on heavy short-covering. The single currency gained 0.6 percent Tuesday and rose as high as $1.3132, well off an 11-month low seen last week of $1.2945.

German government bonds are edging lower ahead of the ECB operation but in very low volumes as the holiday season approaches.

Italian and Spanish government 10-year bond yields have fallen to around 6.62 percent and 5.14 percent respectively, moving further away from the levels above 7 percent that were widely seen as unsustainable.

Sources in Milan have told Reuters more than 10 Italian banks, including major lenders, were looking to apply for the ECB loans by using state-guaranteed bonds as collateral.

But it was also likely that some banks would use the funds to repay their own debts as they strive to get rid of bad assets and improve their balance sheets amid strong regulatory pressures to beef up their core capital.

Analysts say the long-term ECB loans will lower the cost for euro zone banks to borrow euros in the open market, but won't reduce their dollar funding costs.

U.S. stocks rallied nearly 3 percent Tuesday as investors bought surging banks, homebuilders and networking companies, though low volume was seen as amplifying the market's move.

(Additional reporting by Chikako Mogi)