* Banks pull European shares lower after Asia retreats
* Yen, bond yields rise after Japan cabinet backs fiscal package
* Dollar stays weak after soft data, euro tops $1.12
* U.S. crude oil recovers, though supply glut weighs
* Wall Street set to open lower (Adds detail and updates prices)
By Kit Rees
LONDON, Aug 2 (Reuters) - European stocks fell to two-week lows on Tuesday, dragged down by banks, while the yen rose against the dollar and government bonds sold off after Japan's cabinet approved a fiscal stimulus package to revive the flagging economy.
U.S. crude oil headed higher, having briefly dipped below $40 a barrel, although a supply glut still weighed on prices.
Wall Street was set to open lower. Futures on the Dow 1YMc1 , Nasdaq NQc1 and S&P 500 ESc1 were down 0.2 percent.
The pan-European STOXX 600 index .STOXX fell 1 percent, hurt by a 3 percent fall to three-week lows in banks .SX7P . They extended Monday's losses after Europe-wide stress tests raised questions about the health of the sector.
Credit Suisse CSGN.S fell 5.8 percent and Deutsche Bank DBKGn.DE 3.9 percent after index provider STOXX said the two banks would be dropped from Europe's STOXX Europe 50 index .STOXX50 from next Monday. Commerzbank CBKG.DE shares hit a record low, down 8.5 percent after it warned its earnings would fall this year because of customer caution and negative interest rates. banks are hampered by their profitability in various areas and by the low-interest-rate environment. These are additional headwinds on the top of pressures from increasing regulation and from litigation payments," Gerhard Schwarz, head of equity strategy at Baader Bank in Munich, said.
Italy's Monte dei Paschi BMPS.MI fell 9.4 percent and UniCredit CRDI.MI 5.1 percent.
JAPAN STIMULUS
MSCI's broadest index of Asia-Pacific shares outside Japan .MIAPJ0000PUS was down 0.4 percent, after the S&P 500 .SPX ended Monday 0.1 percent lower, despite reaching an intraday record high.
Australian shares fell 0.8 percent after the Reserve Bank of Australia cut its main interest rate to a record low of 1.50 percent, as expected. Hong Kong trading was suspended as Typhoon Nida shut down most of the financial hub.
Sliding oil prices and the stronger yen pushed Tokyo's Nikkei index .N225 down 1.5 percent.
The yen hit its strongest in three weeks at 101.77 per dollar JPY= after Japanese Prime Minister Shinzo Abe's cabinet approved on Tuesday 13.5 trillion yen ($132 billion) in fiscal steps as part of efforts to revive Japan's economy week, the Bank of Japan announced further easing steps, which disappointed investors who had hoped for more.
"There's quite a lot of scepticism in the market as to whether this fiscal package can change anything," said Alvin Tan, a strategist at Societe Generale (PA:SOGN).
"What was exciting over the past month was the potential for monetary policy to act in coordination with the fiscal measures and we were definitely disappointed on that front last week. Coordination still seems a good way off."
Japanese government bonds suffered their worst sell-off in more than three years on fears the BOJ would slow its bond-buying. had a knock-on effect in the euro zone, where government bond yields rose across the board. German 10-year yields DE10YT=TWEB , the benchmark for borrowing costs in the bloc, rose 6 basis points to just above minus 0.1 percent.
DOLLAR STAYS WEAK
With the dollar weakening steadily since weak U.S. growth data last Friday, the euro EUR= rose above $1.12 for the first time in a month.
The dollar fell 0.3 percent against a basket of major currencies .DXY .
The Australian dollar AUD=D4 fell as low as $0.75 after the RBA decision, then recovered to trade up 0.8 percent at $0.7598.
U.S. crude oil futures CLc1 last traded at $40.45 a barrel, up 39 cents. Brent LCOc1 , the international benchmark, rose 64 cents to $42.79.
For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets