Dollar, shares dip as U.S. deadlock continues

By Richard Hubbard

LONDON (Reuters) - World stock markets began to show some more anxiety over a U.S. government shutdown on Wednesday, the lack of progress in Congressional talks undermining faith in a swift and undamaging conclusion to the impasse.

Financial markets had taken a sanguine view of the crisis on the first day of paralysis for the Federal government on Tuesday, European shares amongst others rising to a three-week high.

But there is concern that the longer the shutdown continues, the more likely it is that lawmakers will fail to deal with another potentially more crucial deadline to raise the U.S. public debt ceiling and prevent a government default.

U.S. stock index futures showed Wall Street was set to open 0.6 percent lower after a fruitless day of negotiations in Washington on Tuesday.

The dollar, which had fallen on Tuesday as the shutdown began, fell another 0.5 percent to its lowest since late August against the yen.

"We do fear that as this discussion drags on, volatility in the market will continue to increase," said Patrick Moonen, senior equity strategist at ING Investment Management.

Still, the shutdown would have to drag on for some time to have a substantial effect on the U.S. economy and analysts expect pressure on Republicans who have blocked government funding as part of a campaign against President Obama's healthcare reform may be forced to concede ground.

Global equities, as measured by MSCI's world equity index, were down just 0.3 percent by 1100 GMT having started the new quarter with a 0.9 percent gain on Tuesday.

The cost of insuring U.S. government bonds against default for the next year also rose, gained five basis points to raise the cost of protecting $10 million of debt to $35,000 - the highest since August 31 and above the rate for 5-year insurance.

Usually it costs more to buy longer-term default insurance so the current level is considered a classic sign of credit stress, reflecting the concerns over whether the U.S. would be able to raise the debt limit in coming weeks.

ECB EYED

The euro was drawing support from events in Washington but is hampered by a weak economic outlook that may yet provoke more action - or at least the threat of action - from the European Central Bank, meeting on Wednesday in Paris.

It was steady at around $1.3530, not far from an 8-month high touched a day earlier.

ECB President Mario Draghi has raised the possibility of even looser policies in a bid to prevent market interest rates from rising and undermining economic recovery. [ID:nL6N0HR1TV] But the U.S. Federal Reserve's surprise move not to trim bond-buying last month for now looks to have done the job for him.

"They (the ECB) will stick to their happy talk of being supportive and keeping low rates for a long time," said Luca Jellinek, head of European interest rates strategy at Credit Agricole CIB.

ECB President Mario Draghi has raised the possibility of even looser policies in a bid to prevent market interest rates from rising and undermining economic recovery.

But the U.S. Federal Reserve's surprise move not to trim bond-buying this month and growing likelihood it will keep policy loose for now looks to have done the job for him.

Meanwhile the latest round of political turmoil in Italy has not helped the region's prospects - although there are signs that Prime Minister Enrico Letta was on course to garner enough support to win a crucial vote of confidence, expected later in the day easing the threat of early elections.

Italy's benchmark share index, the FTSE MIB, was up 1.2 percent as the vote neared bucking the trend across Europe which saw the broad FTSE 300 index shed 0.6 percent.

The main barometer of market concern, the premium investors demand to hold Italian 10-year government bonds over AAA-rated German Bunds, fell to 266 points from 300 basis points at the start of the week as 10-year bond yields eased 9.5 basis points to 4.4 percent.

"People in general expect the Italian government to survive," Nordea chief analyst Anders Svendsen said.

In commodity markets, gold edged up from two-month lows below $1,300 an ounce hit when a massive sell order stoked fears of further liquidation Getting some support from the weaker dollar.

Copper futures though had dipped 0.4 percent after posting their biggest quarterly gain since March 2012 thanks to steadier outlook for global growth.

Oil prices softened as a result of the U.S. government gridlock with the November contract down 8 cents percent to $107.86 per barrel.

(Reporting by Richard Hubbard; editing by Patrick Graham)