* Euro retreats after poor industrial output, ZEW numbers * Dollar recovers from 1-month low versus yen * Swedish, UK inflation hits crown, sterling (Updates after European data) By Patrick Graham LONDON, Oct 14 (Reuters) - The euro handed back almost all the previous day's 1-percent rise against the dollar on Tuesday after unexpectedly sharp declines in industrial output and investor morale underlined economic frailty and falling prices. The single currency dropped by a whole cent to $1.2640 and hit an 11-month low against the yen after both euro zone industrial output and the ZEW indicator of German investor sentiment came in well below forecasts. Dealers said large option expiries would help keep the euro within a one-cent range around $1.2650-$1.2750. Inflation in Spain and Italy also remained in negative territory while Sweden's crown was down almost 1 percent after September numbers showed prices falling faster. Broad-based worries about growth have driven stock markets lower and pushed back the expectations of higher U.S. interest rates that sent the dollar higher since July. But traders said it would remain the currency of choice if numbers out of the euro zone continue to offer little hope of a broader economic recovery. "It's become something of an ugly contest and the dollar is the least ugly of the bunch," said Graham Davidson, a spot trader with National Australia Bank in London. "There has been something of a sea change over the past couple of weeks. The dollar is not now going to strengthen because of expectations of higher U.S. rates, it's more that it's people's safe haven of choice." The dollar also jetted almost 0.7 percent higher against the Swiss franc to 0.9550 francs. SPREADS Broadly, a couple of bearish weeks on stock markets - New York shares sank again overnight and European indices were down 1 percent - have called a halt to the dollar's rally since July. The dollar index sank by as much as 1 percent on Monday and it was just 0.2 percent higher on the day on Tuesday. Against the yen, another traditional safe haven for capital in times of economic stress, it was roughly flat at 106.96 yen. By provoking another flight to U.S. and other top-rated Treasury bonds, the stocks sell-off has put a halt to the rise in U.S. yields that were one important driver of the dollar's meteoric gains since July. In contrast, concern that poor or non-existent growth will worsen the debt problems of Italy and other southern European states has raised yields and made government bonds there look more attractive. "It's a bit messy this morning, but to characterise it as 'risk off' would probably be the best way of putting it," said Simon Derrick, head of strategy at Bank of New York Mellon in London. "Clearly there is downward pressure on yields in a lot of places. The irony is that a lot of the bond spreads are moving out in favour of the euro." Sterling took another hit overnight from a sharp fall in September inflation and an unexpected drop in the BRC indicator of retail sales, down 2.1 percent year on year compared with expectations of a 1.0 percent rise. Concern over growth has already driven back expectations for a rise in UK interest rates well into next year. Some analysts who only weeks ago were talking up a rise next month are now saying it may not come until the second half of next year. Money market pricing suggests three-month rates take until after July of next year to factor in a full quarter-point rise in the base rate from 0.5 percent currently. Sterling fell to an 11-month low of $1.5940, down 0.9 percent on the day. (Editing by Ruth Pitchford)

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