* Dollar index drops to near 8-month low
* Dollar losses pared after strong ISM U.S. factory data
* Euro rises to 8-month high, Italy still seen a major risk
By Julie Haviv
NEW YORK, Oct 1 (Reuters) - The dollar edged lower butrebounded from its lowest level in nearly eight months against abasket of currencies on Tuesday as data showing economicresilience assuaged fears about a historic U.S. governmentshutdown.
The greenback sharply pared losses in mid-morning New Yorktrade after an industry report showed the U.S. manufacturingsector last month expanded at its fastest pace in almost 2-1/2years, while firms added the most workers in 15 months.
Fitch Ratings reiterated on Tuesday a partial shutdown ofthe U.S. government is not itself a trigger for downgrading itsAAA sovereign credit rating, but does undermine confidence inthe budget process and raises concerns over whether or not thedebt ceiling will be raised to meet U.S. financial obligations.
The safe-haven yen and Swiss franc, favored during times ofuncertainty, gained against the greenback as the U.S. governmentbegan a partial shutdown, potentially putting up to 1 millionworkers on unpaid leave, closing national parks and stallingmedical research projects.
While the first shutdown in 17 years had some fearing theFederal Reserve would postpone the start of its withdrawal ofmonetary stimulus, most believe it will have a muted impact and,like previous shutdowns, should last from a day to nearly amonth.
The dollar index, which tracks the greenback against abasket of six major currencies, had fallen to 79.864, itslowest since Feb. 13, but last traded at 80.138, down 0.1percent.
"The impact of the government shutdown was relatively mutedin both equity and currency markets," said Boris Schlossberg,managing director at BK Asset Management.
"Today the focus is on Washington D.C., although lawmakersare unlikely to resume negotiations and the dollar could comeunder increasing selling pressure if the situation appears to bedeadlocked," he said.
The dollar's weakness lifted the euro to aneight-month high of $1.3588. Hedge funds bought the singlecurrency, which was also helped by the prospect of Italian PrimeMinister Enrico Letta's coalition government surviving aconfidence vote on Wednesday.
The euro last traded at $1.3534, up 0.1 percent, shruggingoff a rise in German unemployment. Eurozone unemployment alsoremained stubbornly high at 12 percent. Marketparticipants are now eyeing a European Central Bank meeting onWednesday.
Speculation the U.S. government shutdown could prompt adelayed release of the closely watched monthly U.S. jobs reportadded to uncertainty in financial markets.
Reflecting the nervousness, near-term implied volatilities,a gauge of how choppy a currency is likely to be, rose. Theone-month euro/dollar implied volatility rose to 7.5 percent,from around 6.6 percent on Friday.
"We do not know how long this impasse in the U.S. will last.If it persists, there is a chance it will hurt economic growthand affect chances of Fed tapering - all of which is dollarnegative," said Daragh Maher, strategist at HSBC.
"In the short term, it's better to avoid the dollar."
A potentially bigger political battle looms over raising theU.S. government's borrowing authority. Failure to do so bymid-October could result in a historic U.S. default.
The dollar's overall weakness gave some reprieve to the yen,which has been under pressure, with the Japanese government ontrack to raise the national sales tax to 8 percent in April from5 percent.
To soften the tax's impact, Prime Minister Shinzo Abe saidthe government will compile an economic stimulus package worth 5trillion yen in December.
Some are not convinced the economy can absorb the tax hikeand expect more monetary easing from the Bank of Japan.
"There are concerns about whether the economy is robustenough to cope and our suspicion is that the decision increasesthe pressure to ease monetary policy further," Tom Levinson,strategist at ING, wrote in a note.
"While this argues for yen losses, more immediately, U.S.debt ceiling concern leaves dollar/yen vulnerable to a retest of97.50 yen."
The dollar fell against the yen, losing 0.2 percent to 98.04 yen after earlier falling to 97.64 yen, which wasnot far from a one-month low of 97.48 yen hit on Monday,according to Reuters data.
- Budget, Tax & Economy
- government shutdown