* Spot iron ore steady near highest level since April
* Chinese mills may raise prices further on margin squeeze - Morgan (Updates prices)
By Manolo Serapio Jr
MANILA, Nov 3 (Reuters) - Shanghai rebar steel futures rallied more than 2 percent on Thursday to hit their highest level since April, supported by firm demand in top consumer China, which kept spot prices of raw material iron ore at a six-month peak.
Inventory of steel products at mills that are members of the China Iron and Steel Association dropped 1.9 percent to 13.61 million tonnes on Oct. 20 from Oct. 10, Morgan Stanley (NYSE:MS) said.
At the same time, average daily crude steel output among the member mills stood at 1.72 million tonnes on Oct. 11-20, down 1.3 percent from the previous 10 days.
"The drop in production is likely the result of mills' increasing maintenance due to pollution pressure and rising cost," Morgan Stanley analysts said in a note.
"However, the declined inventory level suggests demand remained intact. We expect steel mills to further raise prices in response to the margin squeeze."
Rebar, a construction steel product, on the Shanghai Futures Exchange SRBcv1 closed up 2.4 percent at 2,691 yuan ($398) a tonne, just off its session high of 2,694 yuan, its strongest since April 25.
Among Chinese steel traders, inventory has decreased to the lowest since early August at 8.81 million tonnes as of Oct. 28 and was also 8 percent lower than the same period last year, said Helen Lau, analyst, Argonaut Securities.
"Declining blast furnace utilization rates and low steel inventory will result in supply tightness and steel price increases as steel demand is healthy," Lau said.
Further signs of recovery in China's economy also boosted sentiment. China's services sector grew at the strongest pace in four months in October as new business picked up, a private survey showed. strength in steel prices has supported appetite for iron ore, with the benchmark spot price for delivery to China's Tianjin port .IO62-CNI=SI unchanged at $64.40 a tonne on Wednesday, according to The Steel Index. That was the highest level since April 29.
Iron ore has gained 50 percent this year, far outpacing other commodities such as copper CMCU3 and oil LCOc1 . But it remains outstripped by spot Australian premium hard coking coal .PHCC-AUS=SI which has surged 240 percent this year to $265.50 a tonne on Wednesday amid a shortage of the fuel in China.
The most-traded iron ore on the Dalian Commodity Exchange DCIOcv1 finished 0.3 percent higher at 500.50 yuan a tonne on Thursday. It peaked to 509 yuan on Wednesday, the highest since July 2014.
($1 = 6.7593 Chinese yuan)