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By JeeYeon Park

The Dow dropped on Monday as the budget impasse in Washington threatened the first government shutdown in nearly 17 years.

(Read more: Here comes the DC shutdown: What you need to know)

Stocks took another leg lower in the final half hour of trading after one House Republican member told CNBC that there will be no clean spending bill tonight, marking a government shutdown likely.

The Dow Jones Industrial Average, which tumbled more than 170 points, or 1 percent, in the morning, closed the day 128 points lower, dragged by P&G and United Techs. The blue-chip index traded lower for the seventh day in eighth.

The S&P 500 and the Nasdaq also finished sharply lower. The CBOE Volatility Index (VIX), widely considered the best gauge of fear in the market, jumped above 17.

All key S&P sectors closed in the red, dragged by consumer staples and energy.

The Senate rejected the House of Representatives' budget bill, making the shutdown of many agencies at midnight tonight much more likely. The nation faces its first government shutdown in 17 years.

In a 54 to 46 vote, the Senate stripped provisions that would have delayed the implementation of Obamacare by a year, and instead sent an emergency spending bill to the House, where its fate is uncertain.

(Read more: DC 'shenanigans' may cap stock gains: Bob Doll)

U.S. Treasurys ticked higher, driven by a bid for safe haven assets.

Last week, major averages logged their first weekly drop since August with investors nervous over a potential shutdown.

"Just as one arguing couple can ruin a large dinner party, the sight of a dysfunctional political process is an unwelcomed development for investor confidence in stocks," wrote Nicholas Colas, chief market strategist at ConvergEx Group. "If and when a government shutdown starts, the clock will start ticking on lower GDP growth rates and reductions in corporate earnings."

Many government employees will be furloughed by the absence of a deal, and if the shutdown takes place the Labor Department will postpone issuing its closely-watched monthly employment report scheduled for Friday.

On the economic front, he pace of business activity in the U.S. Midwest increased to 55.7 in September from 53.0 in August, according to the Institute for Supply Management-Chicago. A reading above 50 indicates expansion in the regional economy.

Disappointing economic data from China also sapped investors' appetite for risk. China's final reading of manufacturing activity from HSBC came in at 50.2 in September, lower from a preliminary reading of 51.2 earlier this month. Still, the data was higher from August's 50.1 reading. The Chinese Shanghai Composite outperformed as the region's sole gainer, while Japan's Nikkei index closed down 2 percent.

"This is as good as it gets for the time being. The data reflects the stimulus over the summer but don't expect too sharp an acceleration from here," said Frederic Neumann, co-head of Asian economic research at HSBC.

The pan-European FTSEurofirst 300 was down nearly 1 percent. The Italian blue-chip FTSE MIB index dropped approximately 1.5 percent, suffering its worst session in nearly six weeks.