By Sruthi Shankar and Bansari Mayur Kamdar
(Reuters) -European stocks edged higher on Wednesday, extending gains for a third day, as investors awaited a crucial monetary policy decision from the Federal Reserve amid turmoil in the banking sector.
The pan-European STOXX 600 index inched 0.2% up after a two-day bounce.
The index is up 2.5% so far this week, helped by banking stocks, following a series of measures to stabilise the sector following the collapse of three U.S. banks and trouble at lender Credit Suisse (SIX:CSGN).
"There is still a bit of a relief rally going on off the back of finding a solution to the Credit Suisse situation and some positive sounds coming out of the U.S.," said Jonas Goltermann, deputy chief markets economist at Capital Economics.
The European Central Bank's top brass said they were watching for signs of banking stress from the ongoing financial turmoil but a full-blown crisis is unlikely for now.
European banks slipped 0.2% after jumping nearly 5% in the past two sessions, lifted by UBS' state-backed takeover of Credit Suisse and coordinated actions by central banks to boost liquidity.
The Fed is expected to raise interest rates 25 basis points later on Wednesday, as a political storm brews over the U.S. central bank's oversight of recently collapsed Silicon Valley Bank.
The Fed decision is due at 1800 GMT and Chair Jerome Powell will speak at a news conference half an hour later.
"Markets are very much aware that the Fed is stuck between a rock and a hard place," said Han Tan, chief market analyst at Exinity Group.
"If the dot plot points to a terminal rate that's higher than the 5.1% that FOMC officials forecast back in December, such hawkish clues may prompt another risk-off wave across the equity market."
Traders had priced in a 50 bps rate hike from the Fed earlier this month, but turbulence in the banking system and financial markets pushed them to drastically reduce their bets.
Money market traders are currently pricing in nearly 90% odds for a 25 bps hike, according to CME Group's (NASDAQ:CME) Fedwatch tool. They also see rates peaking at 4.95% by May.
Europe's rate-sensitive real estate sector dropped to a five-month low.
Shares of Aroundtown fell 10%, leading losses on STOXX 600, on concerns the Luxembourg-based real estate company may cancel its dividend, according to two traders.
Earlier in the day, data showed British inflation unexpectedly rose to 10.4% in February, which is likely to prompt the Bank of England to raise interest rates on Thursday.
UK's FTSE 100 index, however, erased early losses and added 0.4% supported by consumer staples. (L)
Marks and Spencer (LON:MKS) Group rose 4.5% after Citi upgraded the British retailer's stock to "buy," saying its savings plan will help margin recovery.