Global Markets - U.S, Italian political risks spark flight to safety

By Richard Hubbard

LONDON (Reuters) - Italian bond yields jumped and European shares fell on Monday as political tension in Italy rattled investors already fearful of a looming U.S. government shutdown.

Ten-year Italian government bond yields rose 31 basis points to 4.73 percent. It was their biggest one-day gain since June, although still far from the level that causes funding problems.

Low risk German bonds yields dropped 3 basis points to 1.69 percent. The euro hit a three-week low against the safer yen at 131.38 yen.

Investors are concerned Italy will be forced into new elections just seven months after the last inconclusive vote, following Silvio Berlusconi's move to pull his ministers out of the ruling coalition on the weekend.

"It seems like they're going to try their best to work out a new coalition government and if that doesn't happen its new elections, and if there's new elections there's going to be a lot of worries in the market," said Ishaq Siddiqi, market strategist at ETX Capital.

The market's worry is that an extended period of political uncertainty in the euro zone's third largest economy would delay much needed reforms and reignite the region's debt crisis.

"Markets have grown accustomed to Italy's dysfunctional politics, but there's a sense that things are now spinning out of control, with potentially dangerous consequences for both Italy and the euro zone," said Nicholas Spiro, who runs specialised consultancy Spiro Sovereign Strategy.

The political instability saw Milan's blue-chip FTSE MIB index fall 2.5 percent in early trade, though the broader FTSEurofirst 300 index index was down a more modest 0.6 percent.

Banking shares were being particularly hit.

US DEADLINE DAY

Aside from Italy, investor are focused on events in Washington where a deadline to avert a federal government shutdown is approaching, threatening to damage a fragile economic recovery.

U.S. law makers hardened their positions over the weekend making passage of a stop-gap spending bill for the new fiscal year by midnight on Monday, less likely.

The growing likelihood of a shutdown was being reflected in U.S. stock futures, where the S&P 500 contract shed 0.8 percent.

MSCI's world equity index, which tracks shares in 45 countries, had dropped 0.6 percent as political deadlock also raises fears over successful outcome to the debt ceiling deadline in October, which ultimately could lead to the U.S. government defaulting on its debt.

However, the MSCI index remains on course for its best quarter since March 2012 and its best month since January as the loose monetary policies by major central banks combined with signs of modest global economic recovery favour equities over alternative investments such as fixed income assets.

Earlier Asian stocks took a big hit from the U.S. fears with MSCI's broadest index of shares outside Japan down 1.2 percent at a two-week low. Still, this index has gained 5.7 percent for the month of September, and had its best month since January 2012. Japan's Nikkei fell 1.5 percent.

The mood lifted the yen across the board. The dollar dropped to 97.89 yen from 98.20 late in New York on Friday, though it falls were cushioned by hopes that Japanese Prime Minister Shinzo Abe might unveil big fresh economic steps on Tuesday.

The tension also took a toll on emerging market currencies, with the Indonesian rupiah and Malaysian ringgit both weakening.

Gold edged higher as the possible U.S. government shutdown prompted safe-haven buying, rising 0.2 percent to $1,337.84 an ounce.

(Editing by Jeremy Gaunt)