* Dollar firms versus basket of currencies
* Yen gains against most majors
* Major U.S. stock indexes fall sharply
* U.S. manufacturing expanded in August (Recasts, updates prices, adds details, comments, changes byline)
By Nick Olivari
NEW YORK, Sept 1 (Reuters) - The yen and dollar rose on Tuesday as fears of further U.S. bank failures overshadowed unexpectedly strong U.S. manufacturing data, boosting the two currencies' safe-haven appeal.
Major U.S. stock indexes <.DJI> <.SPX> <.IXIC> were down nearly 2 percent in afternoon U.S. trading as investors fretted that chatter from hedge funds on a bank failure could prove accurate.
The decline came despite upbeat economic news from the United States and euro zone as well as a stabilization in Chinese shares after a rout on Monday.
The hedge fund talk "is a huge driver" of currency markets, said Dan Cook, senior market analyst at IG Markets Inc in Chicago. "When you have data like we had but the Dow drops, people are running for that safe haven."
In midafternoon trading in New York the dollar index <.DXY>, which tracks a basket of six major currencies, was up 0.8 percent at 78.786, rebounding from a session low of 77.944, according to Reuters data.
The dollar was little changed against the yen
But the yen was up 0.9 percent against the Canadian dollar
The euro was down 0.9 percent against the dollar at $1.4205
WHAT RECESSION?
The U.S. manufacturing sector expanded in August for the first time in more than a year and a half. The Institute for Supply Management's index of national factory activity rose to 52.9 from 48.9 in July. For more see [ID:nN01488041].
Separate data showed pending sales of previously owned U.S. homes raced to a two-year high in July, further evidence the housing market was on a steady recovery path. [ID:nN01449976]
"Clearly, the U.S. data is surprising to the upside," said Jack Iles, senior portfolio manager who helps manage $2.5 billion assets at MFC Global Investment Management in Boston.
But despite a batch of upbeat U.S. economic numbers, major currencies remained in ranges as investors continued to debate about the outlook for the global economy, analysts said.
"At the end of the day, the market is still in wait-and-see mode," said Firas Askari, head of currency trading at BMO Capital Markets in Toronto. "We're getting jostled around by every piece of data that comes out and I don't think there's a consensus that this economy has legs."
Data released earlier also showed euro zone purchasing managers' index (PMI) rose to 48.2 in August against forecasts for a 47.9 reading while German unemployment unexpectedly fell in August. [ID:nLAG003701] [ID:nL1608926]
The data comes before a European Central Bank policy meeting on Thursday widely expected to keep benchmark rates steady at a historic low of 1 percent, with the focus on policymakers' outlook on the economy.
Sterling erased early gains against the dollar and the euro after an unexpected dip in UK manufacturing in August, stoking concerns about the pace of recovery in the British economy. [ID:nLAG003703]
Sterling was down 0.9 percent at $1.6135
In other trading, the Australian dollar