GLOBAL MARKETS-Japan shares rally, U.S. budget fuels caution elsewhere
* Markets subdued, investors distracted by US budget wrangling
* European shares modestly lower, euro inches down
* Japanese stocks bounce as yen falls into quarter end
* Oil slips towards $108 on Iran progress hopes
LONDON, Sept 26 (Reuters) - World shares were in limbo and the dollar hovered near a 7-1/2 month low on Wednesday, as investors eyed the latest battle over the U.S. budget with uncertainty.
Tokyo stocks bucked the trend, however, rallying as talk of a corporate tax cut resurfaced.
European shares saw a choppy start to the day with initial rises quickly fading to leave Britain's, Germany's DAX and France's CAC 40 0.1 lower.
Currency, bond and commodity markets were also in a cautious mood with investors largely focused on U.S. budget negotiations going on in Washington. If not resolved, there may be a shutdown of the government.
"For now everyone is assuming that there will not be an extended government shutdown, but history teaches us that they always go down to the wire," said Daiwa Securities economist Grant Lewis."
Japan's Nikkei was one of the few big movers. It erased early losses to end 1.2 percent higher after Kyodo News reported the government would consider cutting corporate taxes, a proposal that has swung in and out of favour for weeks now.
The bounce in Japanese shares in turn weighed on the yen, already pressured by Japanese selling for month and quarter-end. The dollar popped up to 99.00 yen, from an early 98.46, while the euro gained almost a full yen to 133.83.
Measured against a basket of currencies, the dollar eked out a marginal gain and it was barely changed on the euro at $1.3520.
Elsewhere caution was the watchword, with MSCI's broadest index of Asia-Pacific shares outside Japan flat on the day so far. Shanghai stocks shed 1.2 percent and Singapore lost 0.3 percent.
Wall Street looked marginally brighter as stock futures pointed to the S&P 500 and Dow Jones both snapping a five-day run of losses.
Congress is currently struggling to pass a spending bill to keep the government funded beyond Oct. 1, but that is just a taster for the fight over raising the debt limit.
U.S. Treasury Secretary Jack Lew warned that the United States would exhaust its borrowing capacity no later than Oct. 17, though analysts reckon it could keep paying its debts to at least the end of the month.
"Between now and Monday evening, we expect Congress to pass a continuing resolution (CR) that funds the government to at least November 15, if not longer," Deutsche Bank economists wrote in a client note.
"If a CR is passed in time, or if the government closes for only a day or so, the probability of a debt ceiling impasse is reduced. Critically, under no circumstance do we expect the Treasury to default on its obligations."
In the past, the U.S. dollar and stocks have tended to weaken ahead of such political showdowns, only to rally once the issue was resolved.
So far markets are following the script with the Dow Jones industrial average down 0.4 percent on Wednesday, while the S&P 500 Index faded 0.27 percent. It was the fifth consecutive session of losses for the benchmark S&P 500, the first such period for 2013.
In counterpoint to the softness in stocks, U.S. Treasuries rallied for the fourth straight session as investors took a "just in case" attitude.
Yields on the benchmark 10-year note were hovering at 2.64 percent on Thursday, making a fall of 21 basis points since last week's shock decision by the Federal Reserve to maintain its asset buying program.
That decline has in turn shrunk the yield premium Treasuries pay over 10-year German debt by 10 basis points to 82 basis. Bund yields were a fraction higher at 1.778 percent as European trading gathered pace but were near a six-week low.
In commodity markets, oil prices were pressured by hints of progress between the U.S. and Iran.
Iranian President Hassan Rouhani said in a newspaper interview on Wednesday that he wants to reach a deal with world powers on Tehran's nuclear program in three to six months.
Brent crude for November delivery fell 11 cents to $108.21, while November U.S. crude lost 19 cents to $102.47 a barrel.
Copper futures were off 0.1 percent to $7,189.00 per tonne, while gold eased a couple of bucks to $1,330.51 an ounce.