* Weak demand for U.S. short-term bills highlights debt worries
* High-flying stocks hit as investors pull back from gains
* Dollar edges off near 8-month low vs major currencies
* World share markets, oil, trade in narrow ranges
By Barani Krishnan
NEW YORK, Oct 8 (Reuters) - Interest rates on one-month U.S. government debt hit a 5-year peak on Tuesday and stocks on Wall Street closed lower as anxiety rose on whether the United States will avert a debt default.
With the partial U.S. government shutdown in its second week and only nine days left for Congress to act before an Oct. 17 debt ceiling deadline, markets showed increasing signs of worry. President Barack Obama said he would accept a short-term increase to avoid a default but negotiations have not proceeded.
Obama suggested Republicans were resorting to "hostage" tactics, demanding concessions before raising the federal borrowing limit or passing a budget that would end the partial government shutdown that began last week.
Yields on short-dated bills maturing in the next few weeks rose sharply, and the Treasury sold $30 billion in four-week bills at 0.35 percent, the highest yield since October 2008. Demand was the weakest in four-and-a-half years, as investors have become concerned about the potential for a missed payment if the Treasury's borrowing authority is not extended.
"This is the canary in the coal mine," said Eric Green, global head of rates, currency and commodity research at TD Securities in New York. "You could see this seep into other markets. The next shoe to drop is for stocks to drop further. That's why you want the safety of gold and longer-dated Treasuries."
For its three-year auction, the Treasury sold $30 billion at 0.71 percent, indicating more demand for longer-dated issues.
The one-month T-bill rate rose above the one-month London interbank offered rate, or LIBOR, for the first time at least 12 years, according to Reuters data.
One-month U.S. yields were at 0.36 percent, nearing the same yield as two-year notes, at 0.37 percent. A survey from J.P. Morgan Securities released on Tuesday showed investors continued to raise their holdings of longer-dated Treasuries, in lieu of short-dated bills.
The benchmark 10-year U.S. Treasury note was down 2/32, its yield at 2.6375 percent.
Wall Street's technology-heavy Nasdaq index dropped more than 2 percent at one point after Obama said economic shutdown due to a default would raise the risk of a deep recession.
The Dow Jones industrial average ended down 159.71 points, or 1.07 percent, at 14,776.53. The Standard & Poor's 500 Index was down 20.67 points, or 1.23 percent, at 1,655.45. The Nasdaq Composite Index was down 75.54 points, or 2.00 percent, at 3,694.83.
Global stocks as indicated by the 45-country MSCI world equity index were off 0.7 percent.
Many investors believe Republicans and Democrats can still reach deals on the budget and the debt ceiling. Obama concurred as much by reiterating on Tuesday that the United States has always paid its bills.
Such optimism is causing many investors to bank on a rally once the budget and debt ceiling fights are resolved. While stocks are on the decline, the broad S&P 500 has fallen by only about 3 percent from all-time highs reached in September.
Even so, worries about a default are taking hold among some. The CBOE Volatility Index, a measure of Wall Street's anxiety, rose to 20.66, up from Monday's 19.41 and the first time that index has hit 20 since June, a sign of rising concern. Technology stocks were the worst performers of the day, with the S&P information technology index down 1.3 percent.
"In our opinion markets are a little too complacent. The downside risks are horrendous if there is no resolution and the debt ceiling is breached," said Kevin Corrigan, head of credit at Lombard Odier Investment Managers.
European equities ended down for a second straight session. The broad FTSE Eurofirst 300 index dipped 0.8 percent.
The dollar fell against the perceived safety of the yen to trade at around 97 yen. It had dropped earlier to 96.55 yen, its lowest since Aug. 12.
The dollar index, which measures the U.S. currency's value against a basket of currencies, was up slightly but within striking distance of last week's eight-month low of 79.627. Traders said the currency remained vulnerable to more selling.
The longer the political deadlock runs, the greater the economic damage and the more likely the Federal Reserve will maintain its stimulus program, which has flooded global markets with dollars. The biggest U.S. creditors, China and Japan, have said they are increasingly worried the developments in Washington could wreak havoc on their trillions of dollars of investments in U.S. Treasury bonds.
Banks and investors outside the United States were moving to ensure a steady supply of dollars to cover the critical mid-October period when the government hits the borrowing limit, paying sharply higher premiums in the forward foreign exchange market.
Gold prices were little changed at around $1,320 an ounce, while benchmark Brent crude oil settled up 48 cents at $110.16 a barrel and U.S. crude finished up 46 cents at $103.49.. But the gains were expected to be short-lived given an improved supply outlook and fallout from the U.S. budget crisis.