FOREX-Dollar rallies, oil retreat wipes euro gains

(Changes byline, adds quotes, updates prices)

By Veronica Brown

LONDON, May 28 (Reuters) - The dollar rose against the euro and a basket of major currencies on Wednesday but investors were in cautious mood, trapped between rising German inflation and oil extending its slide from recent record highs.

Annual inflation in three German states topped 3 percent in May, highlighting upside risks to the reading for the euro zone's biggest economy as a whole, due later on Wednesday. In two others it was just short of the 3 percent mark.

The data supported expectations for the European Central Bank to retain its hawkish, inflation-fighting stance despite signs of an economic slowdown seen in recent sentiment surveys from euro zone member states.

Other figures showed the outflow of investment from the euro zone accelerated in March [ID:nFAE002285].

Oil prices fell further from last week's record $135.09 a barrel CLc1, providing a little comfort for dollar investors anxious over the inflationary impact of rising crude prices on the troubled U.S. economy.

Analysts said the euro would probably stay near recent one-month highs as the ECB's policy stance was seen staying intact, but signals of economic weakness could not be ignored.

"We had sentiment data from Europe yesterday which were weak, so of course we get people nervous about second quarter activity, and then we get CPI numbers today underlining the fact that Europe has an inflation issue -- so that muddies the water," Calyon senior currency strategist Daragh Maher said.

By 1122 GMT, the euro was down 0.3 percent on the day at $1.5643 EUR=, having hit a one-month high on Tuesday at $1.5818 according to Reuters data.

OIL UNDERCURRENT

The dollar rallied against a basket of six major currencies, to 72.594 .DXY, and erased earlier losses versus the safe-haven Swiss franc CHF= to trade last at 1.0367 francs.

The Swissie was supported by geopolitical jitters after reports of an upcoming new battle-call video from al Qaeda. But U.S. intelligence officials said there is no new evidence of a direct threat from the group or of it having obtained weapons of mass destruction [ID:nN27305968].

Surging oil prices have fanned fears about the ability of U.S. consumers and businesses to weather the credit- and housing market-led downturn and prevent the economy from sliding into full-blown recession.

Tuesday's U.S. data provided little cheer with single-family home prices plunging a record 14.1 percent in the first quarter [ID:nN27375004] and consumer confidence falling to a 16-year low in May [ID:nN27307173].

Although there was little market reaction to the data on the day, analysts said it added to a broadly dollar-negative outlook.

"U.S. consumer confidence remains under severe downward pressure, suggesting that the economy remains highly vulnerable and that market talk of rate hikes remains wide of the mark," ING said in a research note.

U.S. short-term interest rate futures show that investors widely expect the Federal Reserve to raise interest rates by 0.25 percentage point to 2.25 percent by year-end. FEDWATCH

Wednesday features the release of U.S. durable goods figures for April at 1230 GMT.

(Reporting by Veronica Brown; Editing by Gerrard Raven)