* Investors pare back huge bearish bets on euro, sterling
* U.S. retail sales beat expectations
* Euro zone industrial output rises
* Odds Yellen to become Fed vice chair weigh on dollar (Updates prices, adds Fed outlook)
By Gertrude Chavez-Dreyfuss
NEW YORK, March 12 (Reuters) - The dollar dropped to a one-month low against the euro and a two-week trough against sterling on Friday, as investors pared back large bearish bets on the two European currencies following strong euro zone economic data.
The biggest monthly increase on record in euro zone industrial output in January and an upward revision of figures for December also prompted a modest increase in risk appetite. For details, see [ID:nLDE62B0SD]
The data gave traders further reason to cover record euro short positions, or bets that the euro had room to fall, to prevent losses.
"What we're seeing here is probably corrective strength in the euro and sterling. We had very large (short) positions in these currencies so they are due to bounce anyway," said Nick Bennenbroek, head of FX strategy at Wells Fargo in New York. "And we got some positive news on these currencies, which was a convenient excuse for these to gain."
In the case of sterling, analysts also sought to reduce substantial short trades on the currency -- near an 11-year high -- amid an improving political backdrop in Britain.
An online poll by Angus Reid Public Opinion showed Conservatives are well ahead of the ruling Labour Party, contrasting with other surveys showing the race too close to call. [ID:nLDE62B0IS]
The main concern for markets is that the UK election -- expected in May -- could result in a hung parliament, potentially hampering any incoming government's efforts to cut the UK's ballooning budget deficit.
In late afternoon New York trading, the euro was up 0.7 percent at $1.3759 <EUR=>, hitting session peaks just shy of $1.38, the highest since Feb. 11, according to Reuters data.
Unexpectedly strong U.S. February retail sales data briefly boosted the dollar against the yen and added to optimism about the world's biggest economy. [ID:nN11242539]
The dollar traded flat at 90.44 yen <JPY=>, after earlier rising to a three-week high above 91. The yen is down 1.8 percent against the dollar so far this month.
Traders said the yen's falls may be slowed by repatriation flows ahead of Japan's financial year-end on March 31.
Such flows by Japanese firms may hit a record this year, helped by a tax break to encourage firms to repatriate profits.
The White House said on Friday San Francisco Federal Reserve Bank President Janet Yellen is a leading contender to be nominated to replace Donald Kohn as vice chairman of the U.S. Federal Reserve. [ID:nN12159936]
Chances of a policy dove being named as No. 2 at the U.S. central bank also weighed on the dollar, analysts said, noting that such a move could slow the normalization of the Fed's monetary policy.
Sterling, meanwhile, was up 0.8 percent against the dollar <GBP=D4> at $1.5184, off an earlier high of $1.5218 -- the highest since March 1.
The euro was down 0.2 percent against the pound <EURGBP=D4> at 90.61 pence.
Next week, currency markets will focus on the Federal Reserve's monetary policy decision. The Fed is expected to stay on hold next Tuesday and will likely pledge extremely low rates for an "extended period."
Analysts said they would be watching out for further reference to an exit strategy, although this should not be interpreted as a sign a policy shift is imminent.