FOREX-U.S. dollar founders as shutdown standoff takes toll
* Dollar index at 8-month lows as euro extends gains
* ECB, Italian politics support common currency
TOKYO/SYDNEY, Oct 3 (Reuters) - The dollar rebounded against the yen but struggled close to an eight-month low against a basket of rivals on Thursday as the U.S. government shutdown dragged on and positive developments in Italian politics helped lift the euro.
President Barack Obama met with Republican and Democratic leaders in Congress on Wednesday, but a solution seemed unlikely as both sides dug in for what could be a long stalemate.
The standoff comes a few weeks ahead of the next political battle to raise the federal government's borrowing limit. Failure to do this could result in a worst-case scenario of an historic U.S. debt default.
The common currency added 0.2 percent to $1.3610 after rising as high as $1.3623, a level not seen since early February, with its 2013 peak of $1.3711 set on Feb. 1 in sight.
The euro rallied after Italian Prime Minister Enrico Letta won a confidence vote in parliament as Silvio Berlusconi backtracked on threats to bring down the government.
Adding to the euro's momentum, the European Central Bank reiterated it was ready to use any policy option to temper market interest rates, but did not flag immediate action.
"Overall, we're still seeing a broad risk-on dynamic in the FX market, while we try and wait and see what the developments are in regard to the U.S. shutdown," said Sue Trinh, senior currency strategist at RBC in Hong Kong.
"Risk-on tends to mean that U.S. dollar and yen are the underperformers in that environment," she added.
The euro benefitted from the risk-on sentiment, particularly in light of the European developments.
JPMorgan analysts said there was nothing in ECB President Mario Draghi's comments that suggested the bank was poised to aggressively ease and that declines in money market interest rates since the last ECB meeting have in part lessened the momentum for new measures.
Against the yen, the euro rose 0.6 percent to 132.92 yen , while the dollar added 0.3 percent to 97.66 yen , moving away from the previous session's five-week low of 97.12 yen.
The dollar's weakness against the euro helped push the dollar index down about 0.1 percent to 79.848, though its recovery against the yen kept it off a session low of 79.740 which was its lowest in eight months.
A notable mover was the New Zealand dollar, which initially rallied after the Reserve Bank of New Zealand said larger increases in interest rates would be needed if new limits on mortgage lending fail to cool the country's housing market.
The kiwi last traded down 0.2 percent at $0.8300 after earlier spiking briefly to a high around $0.8340, pulling well away from a two-week trough of $0.8194 plumbed on Wednesday.
Tighter monetary policy in New Zealand would further widen the kiwi's yield advantage over its counterparts in countries like the United States, where interest rates hover near zero.
The RBNZ comments also underpinned the Australian dollar which rose slightly to $0.9387, pulling from an overnight low of $0.9332, according to Reuters data.