* Dollar index drops to near 8-month low
* Dollar losses pared after strong ISM U.S. factory data
* Euro rises to 8-month high, Italy still seen a major risk
By Julie Haviv
NEW YORK, Oct 1 The dollar edged lower but rebounded from its lowest level in nearly eight months against a basket of currencies on Tuesday as data showing economic resilience assuaged fears about a historic U.S. government shutdown.
The greenback sharply pared losses in mid-morning New York trade after an industry report showed the U.S. manufacturing sector last month expanded at its fastest pace in almost 2-1/2 years, while firms added the most workers in 15 months.
Fitch Ratings reiterated on Tuesday a partial shutdown of the U.S. government is not itself a trigger for downgrading its AAA sovereign credit rating, but does undermine confidence in the budget process and raises concerns over whether or not the debt ceiling will be raised to meet U.S. financial obligations.
The safe-haven yen and Swiss franc, favored during times of uncertainty, gained 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.
While the first shutdown in 17 years had some fearing the Federal Reserve would postpone the start of its withdrawal of monetary stimulus, most believe it will have a muted impact and, like previous shutdowns, should last from a day to nearly a month.
The dollar index, which tracks the greenback against a basket of six major currencies, had fallen to 79.864, its lowest since Feb. 13, but last traded at 80.138, down 0.1 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.
"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.
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 $1.3534, up 0.1 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.
Speculation the U.S. government 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'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 dollar fell against the yen, losing 0.2 percent to 98.04 yen after earlier falling to 97.64 yen, which was not far from a one-month low of 97.48 yen hit on Monday, according to Reuters data.