* Dollar stalled as investors focus on rising shares
* Sterling extends loss vs euro; outlook wobbly
* Yen erases earlier losses to rise vs dollar
(Changes byline, adds quotes, updates prices)
By Kirsten Donovan
LONDON, March 10 (Reuters) - The dollar fell against a basket of currencies on Tuesday, retracing much of the previous day's sharp gains as investors focused on stock market gains that have tended to undermine flows into the U.S. currency.
Some easing of wariness towards risk allowed the euro a technical bounce against the dollar, while sterling lengthened losses versus the common currency on continued worries about the health of Britain's banking sector.
Meanwhile, the yen erased losses and rose versus the dollar, though doubts about the Japanese currency's status as a safe port in the global economic storm ensured it kept an overall defensive tone, traders said.
"We're seeing a bit of a risk-on" day, which usually equates to dollar selling," said State Street Global Markets' strategist Lee Ferridge.
"But the market is still very fickle and very nervous at the moment."
The dollar index, a gauge of its performance against six major currencies, fell 0.9 percent to 88.483, off last week's three-year high of 89.624.
European equities rose on Tuesday, with U.S. stock market futures also pointing to a higher open on Wall Street.
But data remained relentlessy gloomy with industrial output in Sweden falling 22.9 percent on the year in January, while UK January industrial output fell at its fastest annual pace since 1981.
Debt issued by the two countries has sold-off since mid-February and Bank of New York Mellon says this could explain the ongoing underperformance of both the crown and sterling against the euro in recent weeks.
"Could it be that this is tangible evidence that, despite the obvious negatives facing the euro zone at present, it still represents a relative safe haven compared to some of its more isolated regional neighbours?" the bank asked in a note.
The euro rose 1.25 percent to $1.2767, rebounding from a three-month low of $1.2455 hit last week according to Reuters data. The euro was also firmer against sterling at 92.04 pence, off a 5-1/2 week high of 92.18 pence.
The euro's gains versus the dollar were briefly dented after ECB Executive Board member Lorenzo Bini Smaghi was quoted as saying the bank was prepared to cut interest rates to zero if deflation threatens and the economic situation worsens.
"The comments are dovish, but they continue to put some distance between themselves and any possible quantitative easing ... They continue to dismiss an outright ECB intervention in the bond market," said Richard McGuire, fixed income strategist at RBC Capital Markets in London.
But, ECB Governing Council member Axel Weber, later said he saw 1 percent as the lower limit for euro zone interest rates.
SHAKY POUND
The pound managed to recover from a six-week low against the dollar, rising 0.7 percent on the day to $1.3871.
But the rebound was on shaky ground after it shed 2 percent on Monday when Lloyds Banking Group intensified sector worries with its announcement the British government was taking a stake of up to 77 percent.
Pressure from the Bank of England's quantitative easing programme was also reflected in bond markets as the yield on benchmark 10 year gilts held near its lowest level in more than 50 years, having fallen below 3 percent on Monday.
The dollar reversed early gains against the yen, last down 0.5 percent at 98.27 yen, but the Japanese currency stayed weaker versus a broadly stronger euro at 125.50 yen.
The yen has fallen in the past month as Japan's economy grapples with diving exports and its worst recession of the postwar era. Its current account balance swung to the largest deficit on record in January, adding to selling pressure.
Market participants say foreign investors have been reducing long positions in the yen, with expectations fading that it can surpass a 13-year peak of 87.10 yen per dollar hit in January.