LONDON, July 24 (Reuters) - Hedge-fund bets that peripheral euro zone bank stocks were set for a fall were confounded on Thursday by better-than-expected results from Spanish banks and bright spots in the bloc's economic recovery.
This combination led some investors to close their negative bets - a practice known as short-covering, which involves buying back shares they had previously borrowed and sold.
Some analysts said market sentiment on the banks was turning and that short-sellers were likely to remain on the sidelines for now.
Shares of Spain's Bankinter and Banco Sabadell were up 1.8 percent and 3.7 percent respectively on Thursday after reporting a pick-up in profit recovery, while Portugal's Banco Espirito Santo and Millennium BCP rose 2.5 percent and 6.4 percent.
A fresh batch of manufacturing PMI data from the euro zone showed some bright spots and was another trigger for the reversal of short bets, traders said.
"You're getting better PMI (data), BES seems to be sorting itself out, the earnings season is good - all of that would point to the upside for peripheral banks," Antonin Jullier, global head of equity trading strategy at Citi, said.
"Going long or at least covering the shorts on peripheral banks is a lot more interesting from a risk return point of view."
Short interest in southern European banks has mounted over the last three months due to weaker economic data in countries such as Italy and Portugal and financial problems gripping Espirito Santo's founding family.
Short sellers borrow a stock and sell it, betting they would be able to buy it back at a lower price before returning it to the lender and collecting the difference.
Nearly 40 percent of BES's lendable stock was out on loan at the market close on Wednesday, 10 times as much as the market average, but down 8 percentage points since the firm said on Tuesday that Goldman Sachs and U.S. hedge fund D.E. Shaw had taken a combined 5 percent stake in it, Markit data showed.
Short interest in Sabadell was 38 percent before it released results, with Millenium BCP and Spain's Banco Popular , which are due to report next week, also heavily shorted, the data showed.
Thomson Reuters indexes of Portuguese, Spanish and Italian banks fell between 10 percent and 25 percent over the past month and a half.
"I had been expecting it (this short covering) for a few days, in light of the recent performance and because results were coming up and there was no reason to believe they would be all that bad," a trader in Milan said.
"The move should last a little while as the catalyst (results) is fairly close and this could lead to an outperformance of financial shares." (Reporting By Francesco Canepa; Editing by Lionel Laurent)