LONDON (MarketWatch) — European stock markets rallied Tuesday to close at their highest level in more than two years as a U.S. deal to extend tax cuts and hopes that the Irish parliament will approve a tough new budget buoyed sentiment.

The Stoxx Europe 600 index (STOXX600) closed up 0.9% to 273.90, its highest closing level since September 2008. U.S. stock markets also advanced in early trading.

The gains came after a U.S. deal to extend Bush-era tax cuts helped offset worries over the possibility that China may hike interest rates.

European Union debt crisis

Sentiment was also buoyed by expectations that Ireland’s parliament is likely to approve a tough new budget after an independent lawmaker agreed to support the government. See story on Ireland’s budget.

“It seems to us that even opposition politicians have little to gain by pushing Ireland into an even bigger crisis. At least that threat is now out of the way,” said Dermot O’Leary, chief economist at Goodbody Stockbrokers.

Dublin’s ISEQ index was one of the strongest performers in the region, rising 1.7% to 2,797.88.

Germany’s DAX 30 index (DAX) climbed above the 7,000 level for the first time since June 2008. The index finished up 0.7% at 7,001.91.

Heino Ruland, strategist at Ruland Research, said the likely approval of the Irish budget may have been a trigger for some buying, but stressed that the main underlying driver is a continued move by investors out of bonds and into equities.

“It’s a change in asset allocation and that will continue to be the name of the game,” Ruland said.

“By the end of next year I can clearly see 8,000 [for the DAX] being at least reached,” he added. That would put the German index at or close to a new all-time high.

Among the continent’s other main markets, the U.K. FTSE 100 (UKX) gained 0.7% to 5,808.45 and the French CAC 40 (PX1) climbed 1.6% to 3,810.50, though both remained below the peaks they hit earlier in 2010.

Bank stocks traded mostly higher, with Lloyds Banking Group PLC (LLOY) up 0.9% and BNP Paribas (BNP) up 2.3%.

The volatile Irish banking stocks also rose strongly. Allied Irish Banks (AIB) AIB, jumped nearly 19%.

But Spain’s Banco Santader (SAN) STD, +3.58% and BBVA (BBVA) BBVA, +0.91% underperformed, slipping 0.9% and 0.2%, respectively, after German Chancellor Angela Merkel on Monday dismissed calls to increase the size of the European Union’s bailout fund or create European sovereign bonds.

Among other stocks in focus, BP PLC (BP.) BP, -3.07% rose 1.1%, leading the oil sector higher as crude-oil prices temporarily climbed above $90 a barrel. France’s Total SA (FP) climbed 1.5% after announcing a plan to sell its specialty chemicals photocure and coatings resins business for 550 million euros.

Retailer Tesco PLC (TSCO) advanced 2.4%. It reported an 8.2% rise in total sales in the fiscal third quarter, which analysts said was slightly better than markets had expected.

Rival J Sainsbury (SBRY) rose 4.3% amid speculation that shareholders in Qatar could launch a takeover bid. See London Markets for more on Sainsbury.

Consumer-goods giant Unilever (ULVR) UL, +0.50% rallied 2.9% in London after it was upgraded two notches to overweight from underweight at Morgan Stanley.

Swiss pharmaceutical group Novartis AG NVS, +0.60% (NOVN) rose 0.7% after it was upgraded to outperform from neutral at Credit Suisse. Bayer AG (BAYN) gained 0.9% after it was also upgraded to outperform by the broker.

In the airline sector, Air France-KLM (AF) reversed early gains to trade down 2.2% after it announced a 4.3% rise in November passenger traffic.

Among smaller companies, U.K. house builder Bellway PLC (BWY) jumped nearly 10% after forecasting growth of up to 20% in pretax profit. The report, along with an update from plumbing supplies firm Wolseley (WOS), helped drive strong gains for several construction-related stocks in the U.K.

Shares of Wolseley rallied 2.7% in London. (WOS)