* Euro hits four-month lows vs dollar, govt bonds rally * Italy's five-year debt cost highest since Oct 2012 * European stocks hit three-week closing low, Wall St. off lows By Wanfeng Zhou NEW YORK, March 27 (Reuters) - Major stock markets fell and the euro slumped to a four-month low against the dollar on Wednesday, hit by a disappointing Italian bond auction and concern about a wider impact on the euro zone from Cyprus's bailout. Bleak euro zone economic data added to a sour tone in markets, driving demand for safe-haven assets. U.S. Treasuries debt prices jumped, with benchmark yields falling to their lowest levels in three weeks and German Bunds also gained. Gold rose above $1,600 an ounce. At a debt auction on Wednesday, Italy paid more to borrow over five years than it has since October as lack of progress in forming a new government and worries about Cyprus hurt demand. Cypriot banks are due to reopen on Thursday. Cyprus is putting the final touches on capital control measures to prevent a run on banks after the country agreed to a bailout deal that will wipe out some senior bank bondholders and impose losses on large depositors. The worry among investors is that despite attempts by some officials to dismiss the idea, the plan could become a blueprint for any future euro zone bailout. "The overhang of the Cypriot bailout, and especially its implications for euro zone-wide banking depositors, along with a dip in confidence and lacklustre Italian debt auctions, have upset the apple cart for U.S. investors determined to assault record stock market highs," said Andrew Wilkinson, chief economic strategist at Miller Tabak + Co, LLC in New York. U.S. stocks fell after a rally on Monday propelled the S&P 500 to within striking distance of an all-time closing high. But they recovered some losses in afternoon trading. The Dow Jones industrial average dropped 23.96 points, or 0.16 percent, to 14,535.69. The Standard & Poor's 500 Index fell 0.79 points, or 0.05 percent, to 1,562.98. The Nasdaq Composite Index slipped 2.36 points, or 0.07 percent, to 3,254.84. MSCI's index of world shares, which tracks 6000 stocks in 45 countries, fell 0.2 percent to 358.73 points. European shares dropped 0.4 percent to end at 1,184.06 points, a three-week closing low. Benchmark U.S. 10-year Treasury notes were up 16/32 in price to yield 1.854 percent. The euro fell as low as $1.2750, the weakest since Nov. 21, and last traded at $1.2778, down 0.6 percent on the day. "Rising Italian borrowing costs and its political situation are both negatives," said Greg Anderson, G10 strategist at Citigroup in New York. "Investors are not overly short the euro, so there is plenty of scope for the euro to test the lows of the past cycle." Data on Wednesday showed confidence in the euro zone's economy fell more than expected in March after four straight months of gains. Other reports showed a slump in Italian manufacturing and retail sales and contraction in France's economy at the end of last year. The dollar was little changed at 94.43 yen, while the dollar index, which tracks the greenback versus a basket of major currencies, rose to a more than seven-month high of 83.302 . The index was last up 0.4 percent at 83.213. German government Bund futures, an asset that investors value in times of increased tension, rose 75 ticks, their biggest jump since inconclusive Italian elections last month rattled markets. Gold rebounded from early losses, with spot gold rising to $1,606.14 an ounce from $1,598.59 on Tuesday, as investors piled money into safe-haven investments. Brent crude rose 35 cents to $109.71 a barrel in choppy trade and U.S. crude futures gained 24 cents to settle at $96.58.