By Richard Hubbard
LONDON (Reuters) - Rising anxiety over the budget deadlock in Washington drove world shares down for a third day on Wednesday, though the expected nomination of Janet Yellen to head the U.S. Federal Reserve lifted the dollar.
Markets were reassured about the outlook for monetary policy after a White House official said U.S. President Barack Obama would nominate Federal Reserve Vice Chairwoman Yellen to head the central bank later in the day.
"Yellen's appointment as Fed chairman will add a significant element of continuity to monetary policy, and markets have reacted well to that," Michael Hewson, senior market analyst at CMC Markets, said.
However, many market participants expected the positive market impact of Yellen's appointment could be shortlived given a lack of progress to end the political wrangling in Washington that could ultimately lead to a U.S. debt default.
Those worries sent European shares to a fresh one-month low, a day after a sharp selloff on Wall street sent the broad Standard & Poor's 500 index down 1.2 percent.
The MSCI's broadest index of Asia-Pacific shares outside Japan also dipped, by 0.3 percent, leaving the MSCI world equity index down 0.2 percent, its lowest level since September 9.
The growing nervousness among investors is being reflected in the equity options market where the implied volatility on euro zone equities, seen as a crude barometer for risk aversion, has jumped 31 percent in two weeks to 21.4.
However, it is still only at two-thirds of the levels seen in summer 2011, during the last major debt ceiling crisis.
The main U.S. fear gauge, the CBOE Volatility Index, is at its highest level since June 20 having risen 21.5 percent in the past two days on heavy volumes.
With only nine days left for Congress to act before an October 17 debt ceiling deadline, President Barack Obama reaffirmed his stance on Tuesday that he would be willing to negotiate only after Republicans agree to re-open the government and raise the debt limit with no conditions.
The tough talk has convinced some investors in the money market to take precautions to protect against the possibility of a U.S. default by shunning U.S. debt maturing in late October and early November.
The yield on four-week U.S. government bills hit a five-year high above 0.3 percent on Tuesday though it has since edged back to 0.26 percent.
However, with the government shutdown disrupting U.S. economic data flows the Fed needs to determine when to adjust its monetary policy. As the economic impact of the partial government closure is likely to take months to discern many are convinced that central bank stimulus will now continue into next year.
The minutes of the Fed's policy meeting on September 17-18 due at 1800 GMT could clarify the outlook slightly with many investors still perplexed as to why the Fed did not scale back its stimulus despite widespread expectations to do so.
The dollar was rising on markets' relief over the prospect of Yellen's appointment although her dovish stance would not normally have supported the U.S. currency.
"In the past when Yellen's nomination became more likely, we saw dollar weakness and suddenly we are seeing dollar strength," said Ulrich Leuchtmann, head of FX research at Commerzbank.
"My interpretation is that we are at the moment in the phase where we might get into very deep trouble with the U.S. budget crisis and if that is the case, it would be good to have a Fed which would be very reactive and this is good for the dollar."
The dollar had gained about 0.5 percent to 97.30 yen, moving away from a two-month low of 96.55 touched on Tuesday. It was also up 0.5 percent against the safer Swiss franc at 0.9084 francs.
German Bund futures, another refuge for investors, were up 22 ticks at 140.44, but were well within a trading range held in October.
The rise came even as Germany aimed to sell 4 billion euros of five-year bonds later, and as investors awaited a report on industrial output after data on Tuesday showed an unexpected drop in German industry orders in August.
The U.S. budget impasse sent oil prices below $110 a barrel on concerns that reduced investor confidence could hurt demand for oil.
(Additional reporting by Anooja Debnath; Editing by Susan Fenton)