* 10-year Treasury yields hit lowest since July 2016
* All three major U.S. stock indexes in the red
* U.S. factory activity contracted in August - ISM
* Dollar briefly hits more than two-year high
* (Updates to U.S. afternoon trading)
By Stephen Culp
NEW YORK, Sept 3 (Reuters) - Benchmark 10-year U.S. Treasury yields fell to their lowest level since July 2016 on Tuesday, and all three major U.S. stock indexes were in the red amid heightened trade worries and a contraction in U.S. factory production.
European shares were also hurt by concerns over a global economic slowdown and uncertainty over Britain's exit from the European Union.
As new tariffs on Chinese goods took effect over the U.S. holiday weekend, market participants appear to be losing faith that the world's two largest economies will reach a near-term resolution to their long-running trade war, which has whipsawed markets for months and strained world economies.
U.S. President Donald Trump said bilateral trade talks with China were going well, but warned he would be "tougher" if negotiations extend beyond the 2020 presidential election.
"This is a risk-off trade day," said Robert Pavlik, chief investment strategist, senior portfolio manager at SlateStone Wealth LLC in New York. "It's really just more concerns about the health of the economy complimented by trade and Brexit, manifesting itself in higher gold prices, a higher dollar and lower Treasury yields."
U.S. manufacturing output shrank in August for the first time in 3-1/2 years, according to the Institute for Supply Management's Purchasing Managers Index (PMI), stoking fears that the global economic slowdown has reached American shores.
"(The ISM data) was confirmation that manufacturing has been in a decline since reaching a peak a year ago," Pavlik added. "It's not a great sign, not the kind of sign you want to see in a slowing economy."
The Dow Jones Industrial Average fell 380.78 points, or 1.44%, to 26,022.5, the S&P 500 lost 28.71 points, or 0.98%, to 2,897.75 and the Nasdaq Composite dropped 104.21 points, or 1.31%, to 7,858.67.
European stocks pulled back from a 1-month high after the disappointing U.S. PMI data compounded worries of a global economic sluggishness, while uncertainty over Britain's hard exit from the European Union put an end to the FTSE 100's four-day winning streak.
The pan-European STOXX 600 index lost 0.23% and MSCI's gauge of stocks across the globe shed 0.67%.
U.S. Treasury yields fell, with the benchmark 10-year yield at its lowest since July 2016 after the downbeat ISM report exacerbated worries about a weakening global economy in the shadow of the U.S.-China trade war.
Benchmark 10-year notes last rose 14/32 in price to yield 1.459%, down from 1.506% late on Friday.
The 30-year bond last rose 27/32 in price to yield 1.9373%, down from 1.973% late on Friday.
Trade and Brexit concerns drove the dollar against a basket of major world currencies to its highest level since mid-May 2017, but the greenback paired its gains following the release of the ISM factory data.
The dollar index rose 0.03%, with the euro up 0.05% to $1.0972.
The Japanese yen strengthened 0.28% versus the greenback at 105.93 per dollar, while Sterling was last trading at $1.2098, up 0.27% on the day.
Rising OPEC and Russian production, combined with demand concerns due to a global economic slowdown dragged down oil prices.
U.S. crude fell 2.69% to $53.62 per barrel and Brent was last at $57.93, down 1.24% on the day.
Gold prices rose more than 1%, with the safe-haven precious metal hovering just below its more than six-year high of $1,554.56.
Spot gold added 1.0% to $1,546.21 an ounce.
Copper lost 0.16% to $5,611.00 a tonne.
Three-month aluminum on the London Metal Exchange rose 0.31% to $1,754.50 a tonne.
Reporting by Stephen Culp; Editing by Bernadette Baum