* China factory activity shrinks at fastest pace in 3 years
* Dollar sags, S&P 500 down
* Crude oil futures drop (Updates with U.S. market closing levels)
By Caroline Valetkevitch
NEW YORK, Sept 1 (Reuters) - World stock indexes and oil prices slumped on Tuesday as weak Chinese data fueled worries about a slowdown in its economy, the world’s second biggest, and sparked more market turmoil.
The fall in oil prices ended a three-day rally that had driven crude up more than 20 percent. Brent fell below $50 a barrel on concerns about global demand for petroleum.
U.S. stocks fell nearly 3 percent, with all three major U.S. equity indexes firmly in negative territory for the year-to-date. The benchmark S&P 500 is down 7 percent since Dec. 31.
The CBOE Volatility index .VIX, known as Wall Street’s “fear gauge”, was up 10.45 percent at 31.40, above its long-term average of 20. The index had spiked to 53.29 on Aug. 24.
The moves followed a stormy week that left investors concerned about further market losses due to slowing growth in China and the effect on the global economy. The S&P 500 on Monday posted its worst monthly decline since 2012.
The recent signs of weakness in big economies has raised doubts about earnings growth and fueled worries about whether central bank support could make a difference after years of loose policy around the globe.
Comments by Federal Reserve Vice Chairman Stanley Fischer over the weekend appeared to keep alive the chances of a U.S. interest rate increase in September.
“It’s general risk aversion manifesting itself after a really bad August,” said Mohannad Aama, managing director at Beam Capital Management LLC in New York. “The continued uncertainty about China is definitely adding to worries.”
Sparking Tuesday’s selloff, surveys showed China’s manufacturing sector shrank at its fastest pace in three years while its services sector also cooled.
Data showing U.S. factory activity hit a more than two-year low in August added to investor jitters.
The Dow Jones industrial average fell 469.68 points, or 2.84 percent, to 16,058.35, the S&P 500 lost 58.33 points, or 2.96 percent, to 1,913.85, and the Nasdaq Composite dropped 140.40 points, or 2.94 percent, to 4,636.11.
MSCI’s all-country stock index fell 2.7 percent and is now down 7.4 percent for the year-to-date. The pan-European FTSEurofirst 300 stocks index closed down 2.8 percent.
In the oil market, Brent crude dropped 8.5 percent to $49.56 a barrel. U.S. crude fell 7.7 percent to $45.41.
While shares and commodities remained the focus, the mood was similarly wary in the currency and bond markets.
U.S. Treasuries prices rose as the Chinese and U.S. data fueled safe-haven bids. Possible selling of long-dated Treasuries by foreign central banks capped those bonds’ gains.
U.S. 10-year Treasuries were last up 8/32 in price to yield 2.17 percent, from a yield of 2.20 percent late on Monday.
The dollar sagged against the safe-haven yen and low-yielding euro as investors unwound bets against the two currencies, which are widely used to fund positions in riskier assets.
The dollar was last off 1.20 percent against the yen, at 119.80 yen, while the euro rose 0.70 percent to $1.1297 .
The head of the International Monetary Fund, Christine Lagarde, summed up the global outlook in a speech in Indonesia, where she said global economic growth was now likely to be weaker than had been expected just a few months ago.
She cited a slower recovery in major advanced economies and a further slowdown in emerging nations and highlighted the need to “be vigilant for spillovers” from China’s stutters.
In the metals markets, benchmark copper on the London Metal Exchange ended at $5,067 a tonne, down 1.3 percent from Friday’s close, as markets reopened after a long holiday weekend.
Gold rose 1 percent as the dollar and global equities dropped. Spot gold rose to a session high of $1,147.16 an ounce. (Additional reporting by Noel Randewich in San Francisco and Marc Jones in London; Editing by Dan Grebler, Meredith Mazzilli and Leslie Adler)