UPDATE 1-Iron ore scores biggest monthly rise and up 5 pct on year
* Iron ore up almost 5 percent in 2012
* Traders say rally may end soon
* Iron ore hits highest since May 1
(add details, updates iron ore prices)
LONDON/SHANGHAI, Dec 31 (Reuters) - Iron ore jumped to a 8-month high on Monday, posting its biggest monthly increase on record, in December, as falling inventories and renewed confidence about China's economic outlook prompted traders and steel mills to restock.
Shanghai steel futures also extended last week's rally and rose nearly two percent on Monday, buoyed by upbeat Chinese manufacturing data and higher raw material prices.
Factory activity in China hit its fastest pace in December since May 2011, a survey of private factory managers showed, with a sub-index for new orders pointing to continued strength for the world's second-biggest economy in the new year.
"Investor sentiment is pretty positive and that optimism is also seen in the Shanghai stock market. Steel investors are looking at higher iron ore prices and thinking steel futures will need to catch up," said a Shanghai-based trader.
The benchmark index for 62-percent grade iron ore <.IO62-CNI=SI> rose $5.50 a tonne to $144.90 a tonne on Monday, its highest level since May 1st according to the Steel Index.
The steel ingredient rose by almost $30 a tonne, or about a quarter, in December, the biggest monthly increase since the Steel Index started assessing daily spot prices in April 2009.
The quick recovery balanced a steep fall registered in the summer, when top consumer China reduced its purchases dramatically, pushing the steel ingredient almost 5 percent up on the year.
The most active rebar futures contract on the Shanghai Futures Exchange was up 1.77 percent at 3,963 yuan ($640) a tonne by midday close on Monday, after easing from a fresh five-month high of 3,969 yuan. The contract is on track to end the year 4.6 percent lower.
The rise in Shanghai rebar came as the price of steel billet in China's key Tangshan area rose to 3,730 yuan from 3,300 on Dec. 27, traders said.
While investors see the lagging 14 percent gain in steel rebar prices this month as a cue that the rally will continue, industry participants cautioned that oversupply of steel in China would rein in gains.
"The rally may continue into early January but will likely start to fall by the middle of next month. China's steel market is oversupplied and that supply-demand disparity will cap prices," said a broker.
Traders said a cargo of 64.5-percent grade of South African ore was traded at $143.50 a tonne on Friday, while a cargo of Australian 61 percent grade iron ore Pilbara Fines was traded at $139 a tonne on China's spot iron ore trading platform.
The swift gain in iron ore prices - which have jumped about 60 percent since their trough of $87 in September - has already dented the appetite of Chinese steel mills, traders said.
"They've been burnt by the last crash and are a lot more wary about holding high stocks now," said a trader. ($1 = 6.2335 Chinese yuan)
(Reporting by Silvia Antonioli in London and Fayen Wong in Shanghai; editing by Miral Fahmy and William Hardy)