* Dollar hits 7-1/2 month low against major currencies
* Wall Street opens lower as budget deal looks unlikely
* World shares weaken but set to end quarter with gains
* Italian bond yields off highs as election fears recede
LONDON, Sept 30 Concerns about a looming political showdown in Washington rattled investors on Monday, sending equities and the dollar lower, though moves that could help Italy's government survive saw Italian shares pare losses.
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 had heightened fears of fresh elections that could delay key economic reforms.
U.S. stocks opened lower, with investors fearful a prolonged government shutdown could have significant implications for economic growth and consumer confidence.
The dollar was down 0.6 percent against a basket of major currencies at a 7-1/2 trough. It was close to a 1-1/2 year low against the Swiss franc and a one month low against the Japanese yen - both currencies investors tend to see as a safe haven for their money in times of financial uncertainty.
Conversely U.S. Treasuries benefited from a view that the economic damage from a government shutdown would be yet another reason for the Federal Reserve to delay scaling back its monetary stimulus.
"It looks like we're heading toward a shutdown but its probably going to be a relatively brief thing," said Phil Tyson, interest rates strategist at brokers ICAP.
Tyson said a bigger risk lay in the upcoming debate over the U.S. government's debt ceiling, which has the potential to cause a default that would rock world financial markets.
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 gain traction 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 0.5 percent and Brent oil fell to less than $108 a barrel.
MSCI's global index, which tracks shares in 45 countries, 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.
In Europe, Italian government bond yields came off their highs after Reuters reported that as many as 20 senators from the centre-right party of Silvio Berlusconi were ready to form a breakaway group if he continues to threaten to bring down Italy's government.
The crisis had escalated over the weekend when the former premier pulled his ministers out of the frail ruling coalition and called for new elections, just seven months after the last, inconclusive vote.
Benchmark 10-year Italian debt yields at one point were up as much as 31 basis points to 4.73 percent on the potential for political paralysis before easing back to be up 16 bpts at 4.61 percent after the report.
The selloff in Italy only had a muted impact on other riskier euro zone government bonds with investors drawing comfort from the improving outlook for the region and an ongoing promise of support from the European Central Bank.
The political instability left Milan's blue-chip FTSE MIB index down 1.6 percent, though it too was off its lows. The broad FTSEurofirst 300 index was down nearly one percent with bank shares taking the brunt of the selling.
The worries saw the euro touch a five month low against the Swiss franc at 1.2218 and it was down 0.8 percent on the yen at 131.78 yen, having earlier fallen to a three-week low of 131.385 yen.
The possibility of a U.S. government shutdown did support gold, which is another refuge for investors in time of uncertainty, leaving the precious metal headed for its best quarterly performance in a year.
Spot gold as trading at $1,335.99 an ounce, building on 1 percent gain on Friday.
Copper also edged up, extending gains it has made on the brighter global economic outlook and adding 0.3 percent to trade at $7,322 a tonne.
"There is obviously a negative economic impact of any shutdown which could weigh on copper. But if a shutdown does occur there is less chance that the Fed will reduce stimulus this year," said analyst Tim Radford at Sydney-based advisory Rivkin.