* Dollar index drops to near 8-month low
* U.S. manufacturing activity slowed in September
* Euro rises to 8-month high, Italy still seen a major risk
* Aussie soars after RBA holds rates
By Julie Haviv
NEW YORK, Oct 1 (Reuters) - Expectations that the first U.S.government shutdown in 17 years could hurt the world's largesteconomy sent the dollar to its lowest level against a basket ofmajor currencies in nearly eight months on Tuesday.
The safe-haven yen and Swiss franc, favored during times ofuncertainty, rose 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.
The historic shutdown could prompt the Federal Reserve topostpone the start of its withdrawal of monetary stimulus,helping push the dollar down to a 1-1/2 year low versus thesafe-haven Swiss franc. Previous shutdowns have ranged from aday to nearly a month.
The dollar index, which tracks the greenback against abasket of six major currencies, fell as low as 79.864,its lowest since Feb. 13. It was last trading at 80.008, down0.3 percent.
"The impact of the government shutdown was relatively mutedin both equity and currency markets," said Boris Schlossberg,managing director at BK Asset Management in New York.
"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.
With attention firmly focused on the U.S. governmentshutdown, the dollar barely reacted to data showing U.S.manufacturing activity grew at its slowest clip in three monthsin September.
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 $1.3554, up 0.2 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.
The Swiss franc hit a 1-1/2 year high of 0.89925 francs perdollar on trading platform EBS.
Speculation the U.S. shutdown could prompt a delayed releaseof the closely watched monthly U.S. jobs report added touncertainty 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 also fell against the yen, losing 0.3 percent to 97.90 yen and moving back toward a one-month low of 97.48yen hit on Monday.
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 Australian dollar soared after the Reserve Bank ofAustralia kept its cash rate at a record low of 2.5 percent, andoffered little guidance on further cuts.
The Aussie jumped 0.9 percent to $0.9392, accordingto Reuters data.
- government shutdown