(Adds analysis, quotes, stocks on the move)
SYDNEY Dec 17 (Reuters) - Australian shares rose 0.7 percent on Tuesday, bouncing back from 3-1/2 month lows as Wall Street gained overnight, but investors remained cautious ahead of an upcoming Federal Reserve policy meeting.
U.S. stocks gained overnight, rebounding from their worst week in months as large deals boosted optimism, bolstering local sentiment.
The financial sector underpinned the market with Australia and New Zealand Banking Group jumping 1.8 percent, while Westpac Banking Corp added 1.5 percent.
The S&P/ASX 200 index climbed 39.8 points, its biggest one-day gain in four weeks to 5,129.4.
The benchmark slipped 0.2 percent on Monday and has taken a beating in recent weeks, having fallen some 350 points from a 5-1/2 year high of 5,457.3 hit on Oct. 28 as profit forecast downgrades and fears over early Fed tapering hit local sentiment.
"With signs of recovery worldwide and stronger economic data, optimism has seemingly returned ahead of the key U.S. Federal Reserve decision due later this week," said Tracey Warren, business development manager at CMC Markets stockbroking.
Australia's central bank on Tuesday said there were signs that past cuts in interest rates are working to stimulate the economy, though it again would not rule out the chance of easing further if needed.
An uptick among in resource stocks also lifted the market as copper hit its highest in nearly two months. World no.4 iron ore miner Fortescue Metals Group rallied 3.2 percent while heavyweights BHP Billiton Ltd and Rio Tinto Ltd added 0.6 percent and 0.9 percent respectively.
A handful of defensives also gained, with consumer staple retailer Wesfarmers Ltd jumping 1.6 percent and telecommunications provider Telstra Corporation Ltd rising 0.3 percent.
Insurance Australia Group shares dropped 4.1 percent to five-month lows of A$5.47 after it raised A$1.2 billion through an institutional equity placement to fund its purchase of Wesfarmers insurance underwriting businesses.
Later in the day, Australia's Treasurer Joe Hockey is likely to unveil a 2013/14 budget deficit of close to A$40 billion, a significant increase on the May budget largely due to an injection of funds to the Reserve Bank of Australia, while the national debt is set to peak above A$400 billion.
Elsewhere, Tellus Resources Ltd gained 2.8 percent after it signed a participation agreement with a private U.S. company, gaining rights to acquire up to 83 percent interest and operatorship in a Utah oil play known as the Covenant Mondo Project.
Pact Group Holdings Ltd, which will begin trading later in the day, said its issue of about 170.7 million shares at an issue price of A$3.80 has been completed.
New Zealand's benchmark NZX 50 index slipped 0.3 percent to 4,721.2. (Reporting by Thuy Ong; Editing by Eric Meijer)