By Anchalee Worrachate

LONDON, Nov 9 (Reuters) European stocks climbed to 5-1/2 year highs on Thursday on a flurry of corporate earnings and merger activity, while the dollar traded in familiar ranges, focusing on U.S. trade data later in the day.

On debt markets, yields for two year maturities rose above those of 10-year paper for the first time in more than six years, while oil prices rose.

Interest rate differentials were also a factor on currency markets as the Bank of England was expected to raise borrowing costs to their highest since 2001.

Traders said European stocks were underpinned by gains on Wall Street which were fuelled partly by a change in the U.S.

political scene.

U.S. Secretary of Defense Donald Rumsfeld resigned a day after Democrats regained control of the U.S. House of Representatives, sparking speculation for a change in Iraq policy and less government spending.

The euro zone government bond yield curve inverted, with yields of two-year bonds rising above those of 10-year paper.

Analysts said the inversion was driven by demand for longer-dated paper from funds and a view that the European Central Bank might risk overdoing its policy tightening from the current 3.25 percent.

European stocks rose on M&A activity, while the FTSE 100 index hit its highest since February 2001.

Scottish Power rallied 3.4 percent to 756 pence after newspaper reports Iberdrola would bid 800 pence per share.

Shares in the Spanish suitor fell 1.4 percent.

While both stocks and bonds also benefited from post-U.S.

election buying, analysts reckon the reaction to the election results will be short-lived and attention will soon return to fundamentals.

''We believe the economy remains the key driver for markets.

With the U.S. economy slowing in response to the housing market slowdown and the increase in interest rates, while inflationary pressures show signs of peaking out, we still believe the next move in the Fed rates will be downwards,'' said James Knightley at ING in London.

''This will keep bond yields under downward pressure over the next six months, dominating any influence from the elections over this time frame,'' he said.

OIL PRICES UP U.S. crude oil futures edged up to a barrel on Thursday, building on the previous day's gains after U.S. data showed a decline in fuel stocks while traders pondered whether OPEC may cut its output again in December.

Gulf members of the producer group said on Wednesday they were fully committed to the 1.2 million barrels per day cut agreed from November.

Oil prices have rallied from below in 2001 to a peak in July. Although energy costs cooled off recently, oil prices remain high by historical standards and continue to worry both bonds and stock investors due to their potential impact on economic growth and inflation.

Gold bounced off previous day's one-week low of 2.90 when it was hit by profit-taking. Spot gold started European trade at 7.70/618.70 a troy ounce before easing slightly to 617.50/618.50 at 0910 GMT.

BOE SEEN RAISING RATES Sterling held steady against the dollar while gilts were little changed as the market braced itself for the expected quarter point rate hike from the BoE at 1200 GMT.

''The pound could rally sharply against the dollar if the Bank of England's expected 25 basis point rate hike to 5.0 percent today is accompanied by the statement that suggests the tightening cycle will continue,'' said Tania Kotsos, strategist at RBC Capital Markets in London.

BoE Governor Mervyn King said recently there was no such thing as a ''done deal'' but all 58 analysts polled by Reuters last week disagreed, predicting the central bank's Monetary Policy Committee would lift rtes to 5.0 percent at this meeting.

A 25 basis point rate hike is also fully priced in the sterling overnight index average (SONIA) swaps market, according to traders.

The dollar was stuck near six-week lows against the euro ahead of U.S. trade and jobless claims data.

The U.S. trade figures at 1330 GMT are expected to show the deficit narrowed to .0 billion in September from the record .9 billion the previous month.

REUTERS SBA HT1943