* Sterling pulls back from fall after S&P cuts UK outlook
* Initial pound selling lifts dollar index from year's low
* Euro/dollar hits 4 1/2-month high, then retreats
(Adds comment, detail, updates throughout)
By Naomi Tajitsu
LONDON, May 21 (Reuters) - Sterling fell sharply against the dollar and euro on Thursday after Standard & Poor's cut its UK ratings outlook to negative from stable, which helped the dollar recover from its lowest level of the year against a basket of currencies.
The pound tumbled as much as 3 cents against the dollar, retreating from a 6 1/2-month high hit in earlier trade after the ratings agency said the UK's debt burden would rise significantly, highlighting the nation's weak fiscal position.
However, sterling trimmed losses following the knee-jerk selling as some in the market reckoned that Britain is only one of many nations facing deep fiscal problems, and other countries may also be vulnerable to outlook and ratings changes.
"It was such a big event that the initial reaction was for cable to fall and that moved the dollar higher," said Paul Mackel, director of currency strategy at HSBC in London.
"The follow-through reaction is that the market has started to realise that if this is happening to the UK, who could be next?
"If they're adjusting the UK's outlook because of fiscal concerns, certainly there are other candidates that would have to go down the same path."
Rival agency Moody's said its stable outlook for its UK Aaa rating is not under review, while Fitch said it had not changed its stable outlook and triple-A rating for Britain.
By 1056 GMT, sterling traded at $1.5643, down roughly half a percent on the day but pulled back from the day's trough of $1.5514 hit after the S&P news.
Traders said that the S&P announcement had triggered a wave of profit taking in the UK currency, which has rallied roughly 6 percent so far this month.
The pound's initial fall helped to lift the dollar index to around 81.180 after it plumbed its lowest level of the year at 80.799 early in the European session. The trade-weighted index tracks the dollar's performance against six currencies.
The dollar had been under broad selling pressure, hitting a 4 1/2-month low against the euro, after the Federal Reserve on Wednesday cut its U.S. economic growth forecasts and left the door open to increasing its asset purchase programme.
The euro was slightly higher at $1.3785. In European trade, it rose as high as $1.3837 according to Reuters data, its highest level since early January, before the S&P announcement dragged the pair down to $1.3742.
Offering some support to the euro was the latest purchasing managers indices for the euro zone, which showed that the pace of contraction in both the service and manufacturing sectors slowed again in May.
The dollar inched up slightly to 94.99 yen, but stayed in range of a two-month low of 94.28 yen hit on electronic trading platform EBS earlier in the day.
WHO'S NEXT?
S&P said that even factoring in further fiscal tightening in Britain, the nation's net general government debt burden may approach 100 percent and remain near that level in the medium term.
Despite downgrading its outlook on the country, S&P maintained its "AAA" long-term and "A-1+" short-term credit ratings on Britain. It later said that the UK faced a one-in-three chance of a ratings downgrade.
The S&P move raised the possibility that the ratings and outlooks of other countries may also come under the same scrutiny as the UK as governments around the world borrow heavily to minimise the impact of the global recession on their respective economies.
Analysts at ING in London said the United States may also be vulnerable to such an adjustment, given that the its debt-to-GDP ratio was worse than the UK's heading into the global financial crisis, and is expected to hit 100 percent before Britain's.
"Today's move begs the question: What will happen to U.S. ratings?" its analysts wrote in a research note.
"The market is right to ask whether a U.S. ratings outlook change could occur shortly -- which would be very bad news for the USD."
The dollar remained on the back foot on Thursday, after the Fed's gloomier outlook and the potential for it to increase the money supply through buying Treasuries and other assets have compounded the dollar's increasingly weak technical outlook.
In addition, analysts say bouts of risk aversion are having increasingly smaller impact on the dollar, after it rose earlier in the year due to safe-haven demand.
Recently, a general rise in equities, a tightening of a range of spreads and falling volatility that suggest the worst of the crisis is over, decreasing the appeal of the U.S. currency.
Instead, resurfacing concerns about the U.S. economy, money supply and a deteriorating technical picture are making it difficult for investors to find reasons to buy the dollar.
Further clues on how strong any U.S. recovery is likely to be could come from the Federal Reserve Bank of Philadelphia's index of business activity in the U.S. mid-Atlantic region at 1400 GMT and weekly data on claims for jobless benefits at 1230 GMT.
(Additional reporting by Jamie McGeever; editing by Victoria Main)