TREASURIES-U.S. bonds flat as government shutdown looms


* Treasuries on track for first monthly gain since April

* Worries over Italian government stoke safe-haven bids

* Chicago PMI highest since May, Dallas Fed index jumps

By Richard Leong

NEW YORK, Sept 30 (Reuters) - U.S. Treasuries prices werelittle changed on Monday after they rose earlier and sent yieldsto their lowest levels in seven weeks on safehaven bids due toworries about a partial government shutdown.

If a budget deal does not materialize later Monday, thegovernment will stop funding nonessential services at midnight,which would cause furloughs of some government employees and,analysts say, act as a drag on the U.S. economy.

This latest chapter of a stalemate over the federal budget,together with the Federal Reserve's decision to refrain fromshrinking its monthly bond purchases earlier this month, havestabilized the Treasuries market following a summer selloff.

U.S. government debt was on track to post its first monthlygain since April and to eke out its first quarterly rise since ayear ago, according to Bank of America Merrill Lynch.

"The best way to say what the market is doing right now isthat it's pricing in a partial government shutdown," said JohnHerrmann, director of interest rates strategy at Mitsubishi UFJSecurities in New York.

Investors, while monitoring for any breakthroughs in thebudget talks in Washington, have also been defensive afterItaly's former prime minister Silvio Berlusconi ordered fivecenter-right ministers to leave the government, threatening thegoverning coalition.

Analysts warned a political collapse in euro zone'sthird-largest economy would hamper efforts to fix its financesand hurt investor confidence in the euro zone block, which hasshown signs of recovery recently.

But on Monday as many as 20 senators from Berlusconi's partywere ready to form a breakaway group unless the former premierbacks down on his hard line to bring down Italy's government.

This development curbed earlier safety bids for Treasuries,German Bunds and other low-risk assets.

Bond demand was also held in check following a report fromthe Institute for Supply Management-Chicago that showed businessactivity in the upper Midwest region grew at its fastest pacesince May. The Dallas Fed said its gauge on Texas manufacturingstrengthened in September to its strongest level since early2011.

Benchmark 10-year Treasury notes were littlechanged in price at 98-28/32 to yield 2.628 percent after theyhad traded up as much as 11/32 with a yield of 2.59 percent.

"We are not in a complete risk-off world. It's a temporarymove to safety," Herrmann said.

Some traders still anticipated a possible last-minute dealin Washington to avert a government shutdown, which would causean unwind of some safe haven bond holdings.

"It's a very fluid situation," said Scott Graham, head ofU.S. government bond trading with BMO Capital Markets inChicago. "The market is trading in a tight range. People aregetting a bit tired of the situation."

The 10-year yield was on course to fall 16 basis points inSeptember for its first decline in five months, but it was stillset to rise for a fourth consecutive quarter.

Treasuries fared better than their German counterparts asthe yield premium on U.S. 10-year debt over 10-year Bunds shrankto 0.83 percent from 0.85 percent on Friday.

While a government shutdown has spurred bids for its debt, aprotracted shutdown, in addition to a looming fight over raisingthe $16.7 trillion debt ceiling, could damage the safe-havenstatus of Treasuries and the U.S. dollar.

The cost to insure against a U.S. default rose to itshighest level since May. Investors would have to pay about35,500 euros annually to insure 10 million euros worth ofTreasuries against a default in five years, up from 31,000 euroson Friday's close, according to data from Markit.

While as many as 1 million federal workers could facepayless paydays if lawmakers won't reach a deal to fund thegovernment, some branches of government including the FederalReserve will stay open.

The U.S. central bank bought $1.47 billion in Treasuriesthat mature in February 2038 to August 2043, the last of itsTreasuries purchases in September for its third round ofquantitative easing, known as QE3.

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