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Dollar off 8 month low as data mutes US government shutdown

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The dollar traded broadly lower on Tuesday, but came off its deepest lows of the day after robust U.S. manufacturing data offset fears that the U.S. government's first partial shutdown in 17 years would clip the economic recovery.

U.S. manufacturing activity expanded at its fastest pace in almost 2-1/2 years, while firms added the most workers in 15 months.

The government's shutdown at midnight after U.S. lawmakers failed to reach a deal on the budget caused a furlough of 1 million federal employees.

(Read more: U.S. government shuts down and the stock market rallies...huh?)

"This is having a muted impact on the dollar, but it all comes down to how long this will last," said Marc Chandler, global head of currency strategy, at Brown Brothers Harriman, New York. "The bottom line is that this has frequently happened in the past 30 years and it is not a crisis. It does not look pretty, but this is how a democracy works."

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Fitch Ratings reiterated on Tuesday that a partial shutdown of the U.S. government is not itself a trigger for downgrading the country's AAA sovereign credit rating, but does undermine confidence in the budget process and raises concerns over whether the debt ceiling will be raised to meet U.S. financial obligations.

A 2011 standoff over the debt ceiling hammered consumer confidence and prompted a first-ever downgrade of the United States' credit rating, a cut by Standard & Poor's to AA-plus.

The safe-haven yen and Swiss franc, favored during times of uncertainty, rose against the greenback. At one point fell the dollar fell to its worst level against the Swiss franc since February 2012, hitting 0.8989 franc before recovering to 0.9051, nearly unchanged on the day. The dollar traded in a tight range against the yen.

(Read more: Is the euro the next currency battleground?)

The dollar index, which tracks the greenback against a basket of six major currencies, hit a near eight-month low of 79.864 before recouping some ground to trade at 80.100, down 0.14 percent.

"Today the focus is on Washington, D.C., although lawmakers are unlikely to resume negotiations and the dollar could come under increasing selling pressure if the situation appears to be deadlocked," said Boris Schlossberg, managing director at BK Asset Management.

The euro rose versus the dollar, hitting an eight-month high of $1.3588 during Asian trading hours, but steadily saw its gains bleed away to trade up just 0.05 percent at $1.3531.

Hedge funds were earlier seen buying the euro, which was also helped by the prospect of Italian Prime Minister Enrico Letta's coalition government surviving a confidence vote on Wednesday.

Market participants are now eyeing a European Central Bank policy meeting on Wednesday.

"We do not know how long this impasse in the U.S. will last. If it persists, there is a chance it will hurt economic growth and affect chances of Fed tapering - all of which is dollar negative," said Daragh Maher, strategist at HSBC.

"In the short term, it's better to avoid the dollar."

(Read more: Debt ceiling? The dollar doesn't care)

A potentially bigger political battle looms over raising the U.S. government's borrowing authority. Failure to do so by mid-October could result in a historic U.S. default.

"The U.S will not default because the executive can prioritize debt payments. President Obama would have to choose default, an impossibility," said Joseph Trevisani, chief market strategist at WorldWideMarkets, Woodcliff Lake in New Jersey.

"Markets will assume that the impossible will not happen. But as Oct. 17th approaches market complacency will turn to jitters, especially if there has been no agreement on the budget. No economic good will come out of Washington's politics of mutually assured destruction," he said.

(Read more: US regulators would stop some operations in shutdown)

The dollar's overall weakness gave some reprieve to the yen, which has been under pressure, with the Japanese government on track to raise the national sales tax to 8 percent in April from 5 percent.

To soften the tax's impact, Prime Minister Shinzo Abe said the government will compile an economic stimulus package worth 5 trillion yen in December.

The dollar fell against the yen, losing 0.36 percent to 7.86 yen after earlier falling to 97.64 yen, which was not far from a one-month low of 97.48 yen hit on Monday, according to Reuters data.

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