* Euro climbs vs dollar, dollar gains pause
* Euro recovers from slide after German industrial data
* Investors reassess possibility of U.S. interest rate rise
(Adds comment, updates throughout)
By Harpreet Bhal
LONDON, June 9 (Reuters) - The dollar fell on Tuesday, pausing for breath following gains in the past few days as investors assessed the likelihood of an earlier-than-expected interest rate hike in the United States.
The euro climbed, reversing losses suffered after an unexpected fall in German industrial output. The data initially sparked selling in the euro, pushing it roughly to the day's low as it added to the view that the euro zone's biggest economy remains weak.
But the euro recovered to hit the day's high, with some analysts citing rising share prices boosting demand for risky trades. European shares traded half a percent higher by 1225 GMT.
The dollar had climbed after optimistic U.S. jobs data late last week stoked the view that U.S. rates may rise from roughly zero at the end of 2009.
But its rally had fizzled by Tuesday as a lack of major economic data or events left traders with few reasons to push the dollar higher.
Analysts said the dollar's move in the past few sessions suggested that monetary policy issues may become a driver of currency movements in the near future, after market participants have focussed on risk appetite for much of the year.
"The dollar's general trend was to weaken on strong data (but U.S.) payroll figures on Friday saw a reverse of that," Steve Barrow, head of G10 FX research at Standard Bank said.
"The market may think that is a sign that markets will focus back on prospects of monetary policy rather than prospects for stock markets as a consequence of economic data," he said.
Traders said they were focusing on economic indicators and auctions for U.S. debt later this week to gauge whether a shift towards a dollar-positive trend will take hold.
A rise in sterling also added to downward pressure to the dollar, as house prices in England and Wales in the three-months to May fell at their slowest annual pace in 1-1/2 years.
Sterling rose 0.7 percent to $1.6172 as traders drew relief as the political storm engulfing UK Prime Minister Gordon Brown appears to have calmed for now.
The euro traded 0.6 percent higher at $1.3987, recovering from lows hit after data showed German industrial output fell by 1.9 percent month-on-month in April.
Despite the data, which was much weaker than economists' expectations for a 0.1 percent rise, the euro recouped some of its losses made on Monday when Standard & Poor's downgraded its sovereign rating on Ireland.
Still, the possibility of more Irish downgrades remained, with ratings agency Moody's saying on Tuesday it was concerned about Ireland and would conclude the review of its AAA rating after a visit to Dublin in the coming weeks.
Some in the market said that the view that Latvia may not have to devalue its currency to deal with extreme economic weakness also provided some support to the euro.
U.S. RATES
The U.S. dollar fell 0.5 percent against a basket of currencies to 80.428, below 81.466 hit on Monday for the first time since May 20.
The dollar fell 0.4 against the yen to 98.05 yen.
Data last week showed the pace of U.S. job losses slowed sharply in May, sparking talk that the Federal Reserve may raise rates later this year and boosting the dollar.
On Friday, U.S. short-term interest rate futures, which track market expectations for Fed rate policy, had their first meaningful move in months -- bringing forward the possible timing of a Fed rate hike to late 2009 from early 2010.
U.S. two-year Treasury note yields stood at 1.350 percent on Tuesday, after rising above 1.4 percent on Monday for the first time in seven months.
Some analysts were unconvinced that speculation of higher rates will heat up even more, arguing that a rise in inflation risks is unlikely this year given that the global economy continues to struggle. Some said it may therefore be premature to reward currencies on rate rise expectations.
"Yes, the deterioration in U.S. data has slowed, but to suggest that this automatically extrapolates the view that the Fed is looking to take back some monetary easing before year end is somewhat injudicious," said Jeremy Stretch, strategist at Rabobank in London.
"It's safe to say that market is getting ahead of itself."
(Additional reporting by Naomi Tajitsu; Editing by Victoria Main)