FOREX-Dollar slumps as chance of U.S. gov't shutdown increases

* Dollar index falls to lowest since February

* Dollar struggles as U.S. government shutdown deadline looms

* Political crisis in Italy weighs on euro

* Euro to remain weighed by ECB policy

By Julie Haviv

NEW YORK, Sept 30 (Reuters) - The dollar dropped against an array of currencies on Monday as an 11th-hour deal to resolve a Washington budget battle remained elusive, raising the possibility of a partial government shutdown as soon as tomorrow.

With a deadline to avert a federal government shutdown fast approaching, the U.S. Capitol remained eerily quiet on Sunday as Republicans and Democrats waited for the other side to blink first and break the impasse over funding.

The high-stakes brinkmanship in Congress will resume on Monday when the Democratic-controlled Senate reconvenes at 2 p.m. (1800 GMT).

Month-end and quarter-end positioning held sizeable sway over market activity, causing the dollar to sharply pare losses against the yen in late morning New York trade, traders said, but uncertainty about a U.S. government budget deal should continue to weigh on the greenback.

The dollar last traded 0.5 percent lower against a basket of six major currencies to trade at 80.154, above an earlier trough of 80.030, its lowest since February.

The index, at current prices, has fallen about 2.4 percent in September, its worst month since October, 2011. For the quarter it notched a roughly 3.6 percent loss, its weakest performance since the first quarter of 2011.

"The potential of a government shutdown could result in a sustained fiscal drag on the economy that could push out any monetary policy normalization by the Federal Reserve," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington D.C.

"Consequently, a government shutdown would likely weigh on the dollar, especially against traditional safe-haven assets like the Japanese yen and the Swiss franc," he said.

Against the yen, the dollar was last down 0.1 percent at 98.14 yen, closer to the session's high of 98.23 yen than a one-month low of 97.48 yen hit earlier in the session.

Against the Swiss franc, the dollar fell 0.2 percent to 0.9038 francs, not far from the 0.9018 francs hit last week, which was its lowest since April 2012.

The U.S. funding standoff is a harbinger of the next big political battle: a far-more consequential bill to raise the federal government's borrowing authority.

Failure to raise the $16.7 trillion debt ceiling by mid-October would force the United States to default on some payment obligations - an event that could cripple its economy and send shockwaves around the globe. Such a scenario should cause further losses for the dollar.

The euro last traded flat at 132.78 yen having earlier fallen to a three-week low of 131.33 yen.

However, the euro gained against the dollar to trade 0.1 percent higher at $1.3534. The euro dominates the composition of the dollar index.

Reflecting the market's nervousness, one-month euro/dollar implied volatility, a gauge of expected price swings and derived from option prices, rose sharply to around 7.40 percent, its highest since early September, up from 6.50 percent last week.

The euro earlier had been weighed down by an Italian political crisis sparked by Silvio Berlusconi's withdrawal of his ministers from the government on Saturday and call for new elections, just seven months after the last vote.

Prime Minister Enrico Letta will seek support in a confidence vote, probably on Wednesday and the possibility of defections from Berlusconi's party could well help Letta avert new elections

"We are in for a risk-off day as we have a bit of a nasty combination of U.S. and Italian political problems," said Arne Lohmann Rasmussen, head of FX research at Danske Bank (Other OTC: DNSKY - news) .

"This is positive for the yen, Swiss franc and sterling. We would not buy the dollar as a government shutdown would reduce the chances of the Federal Reserve 'tapering' its stimulus and that is dollar negative."

The euro could come under further pressure if European Central Bank president Mario Draghi reiterates on Wednesday, when the bank announces its rate decision, that he stands ready to pump more liquidity into the economy if needed.

Analysts at Morgan Stanley (Xetra: 885836 - news) said that although they maintain their long euro position they "adopt a cautious approach. Indeed, the focus will also switch to the ECB meeting this week, where a dovish stance is expected," adding that a move above $1.3570 would be needed for further gains towards $1.3710.

Latest weekly Commodity Futures Trading Commission data showed currency speculators had cut their bets in favor of the dollar to the lowest net long in seven months.

The New Zealand dollar, meanwhile, was the strongest performer versus the dollar among actively traded major currencies, gaining 0.5 percent to last trade at US$0.8318, according to Reuters data.