By Richard Hubbard
LONDON (Reuters) - Jitters over political fights in Washington and Rome rattled investors on Monday, sending world shares and the dollar lower while lifting safe haven assets such as the Swiss franc and Japanese yen.
Deadlock in the U.S. Congress has made it increasingly possible the government will run out of money from midnight, while a split in Italy's ruling coalition has heightened the prospects of fresh elections that could delay economic reforms.
Ten-year Italian government bond yields jumped 31 basis points to 4.73 percent.
"We have a bit of a nasty combination of U.S. and Italian political problems," said Arne Lohmann Rasmussen, head of FX research at Danske Bank.
Adding to market worries was a surprise downward revision to activity in China's factory sector for September, suggesting Asia's economic powerhouse is still struggling to stabilise after a period of slower growth.
Combined with month-end and quarter-end caution among big investors, the end result was a shift out of equities and oil. MSCI's world equity index was down 0.8 percent and Brent oil fell to less than $108 a barrel.
MSCI's global index, which tracks shares in 45 countries, still remains on course for its best quarter since March 2012 and its best month since January as the loose monetary policies of major central banks and signs of modest global economic recovery favour equities over alternative investments.
However, the hunt for safety on Monday saw low-risk German bond yields drop 3 basis points to 1.69 percent. U.S. Treasuries also benefited from a view that the economic damage from a government shutdown would be yet another reason for the Federal Reserve to keep interest rates low for longer.
The euro touched a three-week low against the yen at 131.38 yen and was down 0.2 percent versus the Swiss franc at 1.2225 on concern political shifts in Rome would lead to new elections just seven months after the last inconclusive vote.
The worries have grown following Silvio Berlusconi's move to pull his ministers out of the ruling coalition at the weekend forcing Prime Minister Enrico Letta to go before parliament on Wednesday to hold a confidence vote.
"It seems like they're going to try their best to work out a new coalition government and if that doesn't happen its new elections, and if there's new elections there's going to be a lot of worries in the market," said Ishaq Siddiqi, market strategist at ETX Capital.
Investors are concerned that another extended period of political uncertainty in the euro zone's heavily-indebted, third-largest economy would delay much needed reforms and reignite the region's debt crisis.
"Markets have grown accustomed to Italy's dysfunctional politics, but there's a sense that things are now spinning out of control, with potentially dangerous consequences for both Italy and the euro zone," said Nicholas Spiro, who runs specialised consultancy Spiro Sovereign Strategy.
The political instability led Milan's blue-chip FTSE MIB index to fall 2.5 percent in early trade.
But the selloff was largely contained within the Italian markets as other peripheral euro zone bond yields only edged slightly higher. The broader FTSEurofirst 300 index index was down a modest 0.6 percent though bank shares were being particularly hit.
US DEADLINE DAY
U.S. lawmakers hardened their positions over the weekend making passage of a stop-gap spending bill for the new fiscal year by midnight on Monday, less likely.
The growing likelihood of a shutdown was reflected in U.S. stock futures, where the S&P 500 contract shed 0.8 percent as political deadlock also raises fears over successful outcome to the debt ceiling deadline in October, which could lead to the U.S. government defaulting on its debt.
Earlier Asian stocks took a big hit from the U.S. fears with MSCI's broadest index of shares outside Japan down 1.2 percent at a two-week low. Still, this index has gained 5.7 percent for the month of September, and had its best month since January 2012. Japan's Nikkei fell 1.5 percent.
The tension also took a toll on emerging market currencies, with the Indonesian rupiah and Malaysian ringgit both weakening.
(Additional reporting by Anooja Debnath. Editing by Jeremy Gaunt)