* Treasuries on track for first monthly gain since April
* Possible U.S. government shutdown in focus
* Worries over Italian government stoke safe-haven bids
* Chicago PMI highest since May, Dallas Fed index jumps
By Ellen Freilich
NEW YORK, Sept 30 (Reuters) - U.S. Treasuries prices rose modestly on Monday, leaving yields just above their lowest levels in seven weeks, aided by safe-haven bids on worries about a partial government shutdown.
The U.S. Congress, still in partisan deadlock on Monday over Republican efforts to halt President Barack Obama's healthcare reforms, was on the verge of shutting down most of the U.S. government starting on Tuesday morning.
A shutdown would furlough most government employees and, analysts say, act as a drag on the U.S. economy.
The latest stalemate over the federal budget, together with the Federal Reserve's decision to refrain from shrinking its monthly bond purchases earlier this month, have stabilized the Treasuries market following a summer sell-off.
"The market gapped higher at the open on overseas concerns about the potential shutdown here in the U.S. and also the difficulties with the government in Italy," said John Canavan, fixed-income analyst at Stone & McCarthy Research Associates in Princeton, New Jersey.
Italy's former prime minister, Silvio Berlusconi, had ordered five center-right ministers to leave the government, threatening the governing coalition. But on Monday, as many as 20 senators from Berlusconi's party were ready to form a breakaway group unless the former premier backs down on his hard line to bring down Italy's government.
This development subsequently curbed early safety bids for Treasuries, German Bunds and other low-risk assets.
U.S. government debt was on track to post its first monthly gain since April and to eke out its first quarterly rise since a year ago, according to Bank of America Merrill Lynch.
"The (market) is pricing in a partial government shutdown," said John Herrmann, director of interest rates strategy at Mitsubishi UFJ Securities in New York.
A report from the Institute for Supply Management-Chicago that showed business activity in the upper Midwest region grew at its fastest pace since May kept the bid for U.S. Treasuries in check, however. In addition, the Dallas Fed said its gauge of Texas manufacturing strengthened in September to its strongest level since early 2011.
In late trade, benchmark 10-year Treasury notes were up 3/32 in price, yielding 2.616 percent. They had been up as much as 11/32 earlier, yielding 2.59 percent.
"We are not in a complete risk-off world. It's a temporary move to safety," Herrmann said.
Besides the wariness that fed a preference for U.S. debt - stock prices fell on Monday - month-end index-related buying and quarter-end portfolio rebalancing supported bonds, Canavan said.
Some traders still anticipated a possible last-minute deal in Washington to avert a government shutdown, which would cause an unwinding of some safe-haven bond holdings.
"It's a very fluid situation," said Scott Graham, head of U.S. government bond trading with BMO Capital Markets in Chicago. "The market is trading in a tight range. People are getting a bit tired of the situation."
The 10-year yield was on course to fall 16 basis points in September for its first decline in five months, but it was still set to rise for a fourth consecutive quarter.
Treasuries fared better than their German counterparts as the yield premium on U.S. 10-year debt over 10-year Bunds shrank to 0.83 percent from 0.85 percent on Friday.
While a possible government shutdown has spurred bids for U.S. debt, a protracted shutdown, in addition to a looming fight over raising the $16.7 trillion debt ceiling, could damage the safe-haven status of Treasuries and the U.S. dollar.
The cost to insure against a U.S. default rose to the highest level since May. Investors would have to pay about 35,500 euros annually to insure 10 million euros worth of Treasuries against a default in five years, up from 31,000 euros on Friday's close, according to data from Markit.
While as many as 1 million federal workers could face payless pay-days if lawmakers do not reach a deal to fund the government, some branches of government, including the Federal Reserve, will stay open.
The U.S. central bank bought $1.47 billion in Treasuries that mature in February 2038 to August 2043, the last of its Treasuries purchases in September for its third round of quantitative easing, or QE3.
The Federal Reserve Bank of New York's open market desk said it plans to purchase approximately $45 billion in Treasury securities in October, as it did in September.