GLOBAL MARKETS-Europe sags on Italy concerns, lending weakness
* European shares, euro falls on weak data, Italy tensions
* Investors distracted by U.S. budget wrangling
* Wall Street hoping for first gains in 5 sessions
* Japanese stocks bounce as yen falls into quarter end
* Oil slips towards $108 on Iran progress hopes
LONDON, Sept 26 (Reuters) - Fresh signs of euro zone economic fragility and rising political pressure in Italy hit the euro and the region's shares on Thursday, adding to wider market worries about a potential U.S. government shutdown.
Lending data from the European Central Bank showed that lending to companies fell in all of the euro zone's big countries in August, highlighting the questionable strength of the currency bloc's economic recovery.
Attention was also back on Italy as allies of scandal-hit former Prime Minster Silvio Berlusconi renewed threats to bring down the coalition government if he is barred from politics as part of his punishment for tax fraud.
Italian shares slumped 1.7 percent, leading a sea of red on European stock markets, and Italian government bonds were the region's worst performer too as yields - which move inversely to prices - climbed 10 basis points.
"This is the latest in a series of politically noisy events that threatens not only the stability of the current government, but the longer-term reform process more generally," Timo del Carpio, European economist at RBC Capital Markets, said.
The euro, at $1.3492 by midday, was having its weakest day against the dollar in three weeks and in addition to the falls in Milan, London's FTSE, Germany's DAX and France's CAC 40 dropped 0.1, 0.3 and 0.4 percent.
BANGING ON THE CEILING
Elsewhere most investors were protecting positions as rhetoric in the United States sharpened over budget talks.
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 Nov. 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 before 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.
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 2.624 percent, making a fall of roughly 25 basis points since last week's shock decision by the Federal Reserve to maintain its asset buying programme for now.
That decline has in turn shrunk the yield premium Treasuries pay over 10-year German debt though the euro zone rumblings on Thursday expanded the gap again as Bund yields hit a six-week low of 1.758 percent.
In commodity markets, oil prices were pressured by hints of progress between the U.S. and Iran.
Brent crude for November delivery fell as low as $108 before a minor rebound, while November U.S. crude hovered at $102.68 a barrel.
Copper futures were up 0.5 percent to $7,237 per tonne, while gold edged up a couple of bucks to $1,334.90 an ounce.
Japan's Nikkei was one of the few big risers. 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 at one point the euro gained almost a full yen..
Measured against a basket of currencies, the dollar eked out a marginal gain and it was barely changed on the euro at $1.3520.
MSCI's broadest index of Asia-Pacific shares outside Japan was flat on the day. Shanghai stocks shed 1.2 percent and Singapore lost 0.3 percent.
But on Wall Street, stock futures pointed to the S&P 500 and Dow Jones both snapping a five-day run of losses.