European banking stocks saw a turnaround in their fortunes in the second half of last year on the back of a steepening yield curve as central banks backed off from policies that had pushed interest rates to record lows and pressured profitability at banks.

The sector <.SX7P> is up nearly 50 percent from a 5 1/2 year low hit in 2016.

"With positioning not yet a concern we see room for another leg to the Banks rally in Europe," BAML's European strategists said in a note.

The rally in banks has been fuelled by U.S.-led hopes of governments spending more on infrastructure, sparked by the election of President Donald Trump who has also pledged to cut taxes, which have all stoked inflation expectations and sent bond yields higher.

BAML's European strategists said that the banking sector's returns are most highly correlated to rising rates and inflation expectations, and emphasized their preference for banks exposed to higher dollar rates, stronger capital markets and Italy, where a clean-up of the banking system is underway.

On the flipside, BAML strategists recommended investors avoid "markets with potential trap doors", such as the UK, Spain and Germany.

BAML also cut its exposure to European media <.SXMP> and added that they would avoid such sectors which are a negatively correlated to rising inflation, especially in the UK.

(Reporting by Kit Rees, Editing by Vikram Subhedar)

By Kit Rees