* Weak Chinese factory, euro zone sentiment data hit global stock markets
* Bernanke's comments on reducing bond-buying weigh on markets
* Nikkei drops 7 pct, Wall Street down for second day
* Yen gains more than 2 pct vs dollar and euro
By Ryan Vlastelica
NEW YORK, May 23 (Reuters) - Stock markets worldwide fell sharply on Thursday as surprisingly weak data from China and Europe raised worries about slow growth a day after U.S. Federal Reserve chief Ben Bernanke broached the possibility of reducing stimulus that has buoyed investor confidence.
Japanese shares were hit hardest in overnight action, with the Nikkei losing 7.3 percent, its biggest one-day fall in two years. Investors retreated to safe-haven currencies.
At the session peak, the yen rose more than 2 percent against the dollar and the euro, which both lost 1 percent against the Swiss franc , also seen as a safe haven.
U.S. stocks were lower, but off the day's worst levels, with the S&P 500 down 0.35 percent.
Chinese factory activity shrank for the first time in seven months, adding to concerns that the world's second-biggest economy had stalled. European factory sentiment dropped, suggested that the euro zone's economy was likely to contract again in the second quarter.
"Even though we were overdue for a correction, the Chinese data certainly didn't help things. If it proves to be part of a trend, that's very concerning for the global economy," said Eric Green, senior portfolio manager at Penn Capital Management in Philadelphia, which oversees $7 billion.
The data gave investors a reason to extend Wednesday's sell-off, sparked after testimony from Bernanke that cast uncertainty over when the Fed would begin to reduced stimulus.
Fed officials have started to talk more openly about pulling back on stimulus that has held U.S. Treasury yields near record lows, creating a favorable environment that has produced sharp rallies in stocks and high-yield corporate bonds.
Bernanke said that if economic improvement continued, the Fed "could in the next few meetings take a step down in our pace of purchases," although Fed officials have been at pains to stress that no action is likely for months.
The program is seen as a major contributor to the massive equity gains that have taken indexes to record highs this year, and many analysts worry that the U.S. economy is not strong enough to continue outperforming without it.
"This is a critical period now for the markets. Investors have to adjust for the fact that the Fed's quantitative easing is not going to support the equity markets for an unlimited period," said Nick Beecroft, senior market analyst at Saxo Capital Markets.
U.S. light crude oil, which is closely tied to the pace of economic growth, fell 1.4 percent. The U.S. dollar index fell 0.6 percent.
The Dow Jones industrial average was down 8.68 points, or 0.06 percent, at 15,298.49. The Standard & Poor's 500 Index was down 5.62 points, or 0.34 percent, at 1,649.73. The Nasdaq Composite Index was down 6.53 points, or 0.19 percent, at 3,456.77.
The Euro STOXX 50 Volatility Index, Europe's widely used measure of investor risk aversion, surged nearly 15 percent to a three-week high. The CBOE Volatility Index rose 3 percent.
Concern the Fed will wind down its stimulus initially took its toll on bonds, but investors' sales of equities caused money to flow into safer government debt, leaving yields on U.S. Treasuries and German Bunds down from their highs. The benchmark 10-year U.S. Treasury note was down 1.32 in price, the yield at 2.0386 percent.
Investors expect the bond market will have to adjust to changing Fed policy, and that suggests higher yields in the coming months.
Demand for riskier euro zone debt softened, although bonds remained underpinned by expectations the European Central Bank may yet ease monetary policy further. That would contrast with any tightening by the Fed but follow a massive stimulus package launched by the Bank of Japan.
"Whilst a slowing of QE is possible in a few months we can't help (but) think that the Fed could be forced to restart its QE in a beggar-thy-neighbor environment where central banks in most parts of the developed world are still largely on an easing bias in order to steal a share of the global GDP," Jim Reid, strategist at Deutsche Bank (Xetra: 514000 - news) said in a research note.
"We think QE or derivations thereof will be around for many years to come."