By Kevin Buckland

TOKYO, Oct 4 (Reuters) - Australia's dollar sank on Tuesday after the nation's central bank surprised markets with a smaller-than-expected interest rate hike while sterling extended its recovery a day after the British government's about-face on controversial tax cuts.

The Aussie slumped as much as 0.97% and was last trading 0.5% weaker at $0.6482.

The Reserve Bank of Australia said it decided to slow the pace of tightening because the cash rate had increased substantially in a short period of time, although policymakers left the door open to additional hikes.

"Obviously the RBA hasn't been persuaded by what other central banks are doing, which does make the comment that they don't have any concerns about the exchange rate down here," said Ray Attrill, head of FX strategy at National Australia Bank in Sydney.

"There's no evidence yet that other central banks are about to step down the aggression with which they are tightening policy, (so) I think it makes sense for Aussie to be below 65 for the time being."

Heading into the RBA decision, the risk-sensitive currency had been tracking a little below the top end of its range since Sept. 23 at $0.6537. It sank to a 2-1/2-year low of $0.63635 last week, weighed down by global recession worries.

Sterling rose 0.08% to $1.1333 after earlier reaching $1.13435, the highest level since Sept. 22, the day before the new government roiled markets with its mini-budget of massive tax cuts funded by expanded borrowing.

British Prime Minister Liz Truss was forced to back down from the plan on Monday amid a party rebellion.

The euro also hovered close to the highest since Sept. 22, last changing hands 0.15% stronger at $0.9838.

The U.S. dollar lost some support from a slide in Treasury yields overnight after local economic data showed a slowdown in manufacturing, hinting that aggressive Federal Reserve rate hikes are already being felt.

The dollar index - which measures the currency against six peers including sterling and the euro - was about flat at 111.55, not far from Monday's low of 111.46, a level last seen on Sept. 23. It had soared to a two-decade high of 114.78 last Wednesday.

On Monday, the Institute for Supply Management's (ISM) survey showed U.S. manufacturing activity was the slowest in nearly 2-1/2 years in September as new orders contracted, with a measure of factory gate inflation decelerating for a sixth consecutive month.

Commonwealth Bank of Australia, though, predicts sterling's respite will be short-lived and that the dollar rally has further to run.