* Dollar stalled as investors look to U.S. shares
* Sterling extends loss vs euro; outlook wobbly
* Bini Smaghi comments sap some euro strength
* Yen erases earlier losses to rise vs dollar
(Changes dateline, byline, adds quotes, updates prices)
By Veronica Brown
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 gains for stocks 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 Britain's banking sector.
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've got the standard market dynamics regarding risk," said Jeremy Stretch, markets strategist at Rabobank in London. "With equity futures trading positively in the U.S. then risk appetite is looking a little firmer and the dollar is giving back its gains."
"Euro/dollar is holding up despite the fact that industrial output data seen this morning shows it's falling off a cliff," he added.
Industrial output in Sweden fell 22.9 percent on the year in January, while UK January industrial output fell at its fastest annual pace since 1981.
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.
The euro rose 0.8 percent to $1.2709, rebounding from a three-month low of $1.2455 hit last week according to Reuters data. The euro was also firmer against sterling at 91.73 pence, off a 5-1/2 week high of 92.18 pence.
U.S. stock market futures pointed to a stronger Wall Street open. Citigroup shares were in focus after a memo from Chief Executive Vikram Pandit obtained by Reuters said it was profitable in the first two months of 2009 and confident about its capital strength.
The euro's gains versus the dollar were dented slightly 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.
SHAKY POUND
The pound managed to recover from a six-week low against the dollar, rising 0.7 percent on the day to $1.3824.
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 fell below 3 percent for the first time in more than 50 years on Monday.
"We are in a situation where sterling is perceived as a weak currency, with economic news regularly confirming a pessimistic view on the UK as an economy that is struggling," said Chris Gothard, currency strategist at Brown Brothers Harriman in London.
The dollar reversed early gains against the yen, last down 0.5 percent at 98.28 yen, but the Japanese currency stayed weaker versus a broadly stronger euro at 124.97 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.
Recessions in many of Japan's export markets have dried up overseas demand for its goods, meaning exporters also have fewer dollars to sell in exchange for yen, traders say.
(Additional reporting by Jessica Mortimer and Naomi Tajitsu in London)
(Editing by Patrick Graham)