European stocks fell on Wednesday and government bonds ticked higher after investors turned cautious after optimism about the global economy pushed world stocks to fresh 7-1/2 highs and sterling to 2009 peaks earlier.

Upbeat U.S. housing data on Tuesday was followed on Wednesday by a survey showing the rate of contraction in the euro zone's service sector eased further in May and a report showing surprise first-quarter growth in Australia's economy.

While acknowledging the worst may be over for the world economy, investors are reluctant to push the rally in risky assets further before getting more solid evidence of an economic turnaround.

A private-sector survey on U.S. employment and factory orders data later will provide more fodder to that debate.

The euro zone purchasing managers index was revised higher to 44.8 in May from an earlier estimate of 44.7, and 43.8 in April.

Certainly, the probability of a long, deep recession has receded considerably over the past couple of weeks. The idea that interest rates are expected to remain low should further support the market, said Luc Van Hecka, chief economist at KBC Securities. MSCI world equity index rose as high as 255.16, its highest since mid-October, before slipping 0.2 percent on the day. The index has risen 12 out of past 13 weeks and is now up 12 percent this year.

The FTSEurofirst 300 index <.FTEU3> fell 1.0 percent while emerging stocks <.MSCIEF> were flat.

We believe the downside and upside risks to equities are now quite symmetrical and believe strongly that the lows have been seen, Credit Suisse said in a note to clients.

The upside risk to equities is further aggressive quantitative easing. We believe we are in a range trading market like the 1970s.

U.S. crude oil was steady at $68.55 a barrel.

Oil and other commodities, priced in dollars, drew support after data showed Australia's economy grew a stronger-than-expected 0.4 percent in the first quarter, thanks to the best trade performance in almost half a century.

The recent surge in commodity prices appears to have been driven primarily by hopes of a strong recovery in the global economy rather than by the fall in the dollar or fears of a more widespread pick-up in inflation, Capital Economics said in a note.

This is reassuring, but the rally is still on shaky ground.

STERLING SURGES

Sterling was one of the best performing currencies, hitting seven-month highs of $1.6664 and 160.40 yen. It rose to a six-month high of 85.77 pence per euro. On a trade-weighted basis, it hit a 2009 high of 83.1.

The low-yielding yen fell 0.7 percent to 96.39 per dollar. The Australian dollar hit an eight-month high $0.8265, its highest since late September.

The dollar <.DXY> rose 0.2 percent against a basket of major currencies, having been under pressure in recent weeks.

The yield on benchmark 10-year Japanese government bonds rose to 1.550 percent, its highest in more than seven months. Government bond yields around the world have been rising in recent sessions because of worries over mounting debt in Western governments.

The June Bund future rose 20 ticks.

(Additional reporting by Atul Prakash, editing by Mike Peacock)

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