* 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 largest economy sent the dollar to its lowest level against a basket of major currencies in nearly eight months on Tuesday.
The safe-haven yen and Swiss franc, favored during times of uncertainty, rose against the greenback as the U.S. government began a partial shutdown, potentially putting up to 1 million workers on unpaid leave, closing national parks and stalling medical research projects.
The historic shutdown could prompt the Federal Reserve to postpone the start of its withdrawal of monetary stimulus, helping push the dollar down to a 1-1/2 year low versus the safe-haven Swiss franc. Previous shutdowns have ranged from a day to nearly a month.
The dollar index, which tracks the greenback against a basket of six major currencies, fell as low as 79.864, its lowest since Feb. 13. It was last trading at 80.008, down 0.3 percent.
"The impact of the government shutdown was relatively muted in 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 lawmakers are unlikely to resume negotiations and the dollar could come under increasing selling pressure if the situation appears to be deadlocked," he said.
With attention firmly focused on the U.S. government shutdown, the dollar barely reacted to data showing U.S. manufacturing activity grew at its slowest clip in three months in September.
The dollar's weakness lifted the euro to an eight-month high of $1.3588. Hedge funds bought the single currency, which was also helped by the prospect of Italian Prime Minister Enrico Letta's coalition government surviving a confidence vote on Wednesday.
The euro last traded at $1.3554, up 0.2 percent, shrugging off a rise in German unemployment. Eurozone unemployment also remained stubbornly high at 12 percent. Market participants are now eyeing a European Central Bank meeting on Wednesday.
The Swiss franc hit a 1-1/2 year high of 0.89925 francs per dollar on trading platform EBS.
Speculation the U.S. shutdown could prompt a delayed release of the closely watched monthly U.S. jobs report added to uncertainty in financial markets.
Reflecting the nervousness, near-term implied volatilities, a gauge of how choppy a currency is likely to be, rose. The one-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 growth and affect chances of Fed tapering - all of which is dollar negative," 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 the U.S. government's borrowing authority. Failure to do so by mid-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 97.48 yen hit on Monday.
The dollar's overall weakness gave some reprieve to the yen, which has been under pressure, with the Japanese government on track to raise the national sales tax to 8 percent in April from 5 percent.
To soften the tax's impact, Prime Minister Shinzo Abe said the government will compile an economic stimulus package worth 5 trillion yen in December.
Some are not convinced the economy can absorb the tax hike and expect more monetary easing from the Bank of Japan.
"There are concerns about whether the economy is robust enough to cope and our suspicion is that the decision increases the 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 of 97.50 yen."
The Australian dollar soared after the Reserve Bank of Australia kept its cash rate at a record low of 2.5 percent, and offered little guidance on further cuts.
The Aussie jumped 0.9 percent to $0.9392, according to Reuters data.