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.