* European markets down after China sell-off
* Treasury yields at 7-year highs set tone
* U.S. out for Columbus Day holiday
By Virginia Furness
LONDON, Oct 8 (Reuters) - European markets fell heavily on Monday as investor confidence took a knock from last week's spike in Treasury yields and from a Chinese market slump brought on by concerns that an escalating trade war with the United States could dent China's growth.
Chinese stocks returned from a week's holiday to record their biggest one-day drop since February, with the Shanghai-Shenzhen CSI300 down more than 4 percent for only the second time in more than 2-1/2 years.
This helped set the tone for the European open and stock markets fell with the pan-European index down 0.7 percent and Germany's DAX 0.8 percent lower.
The MSCI world equity index, which tracks shares in 47 countries, fell 0.34 percent.
The fall in global equities boosted demand for the dollar as investors rushed for safety. Against a basket of its rivals the greenback rose 0.3 percent, edging towards a 14-month high hit in mid-August.
Investor fears of higher U.S. interest rates, global protectionism, emerging market weakness and an Italian budget row have all combined to send equities sharply into the red in October, with world stocks down more than 2 percent already.
The dark mood in China sent shivers across Asian markets and will add to investors nervousness - the MSCI benchmark emerging markets index dropped 0.7 percent to its lowest level since May 2017, and is now down 22 percent from January’s peaks.
Growth concerns led the People's Bank of China (PBOC) on Sunday to cut the level of cash that banks must hold as reserves, aimed at lowering financing costs as policymakers worry about the fallout from the tariff row with the United States.
"China just cut reserve requirement ratios and expanded monetary policy, which is a response to the fact that China’s economy is slowing down but the market doesn’t believe there is enough stimulus to cut the slowdown," said Guillermo Felices, a senior strategist at BNP Paribas Asset Management, calling the current concerns markets face a "powerful cocktail".
"They've injected more liquidity into the market to contain the slowdown, which has already translated into weaker equity prices."
The Chinese slide comes after U.S. Treasury yields hit seven-year highs on Friday following strong data that signalled a continued tightening of the labour market and increased inflationary pressures - adding to the reasons for the U.S. Federal Reserve to continue with its hiking cycle.
U.S. trading is likely to be muted on Monday, with markets closed for Columbus Day.
Renewed concerns over Italy's budget also added to the risk-off tone in European equities. The FTSE MIB skidded 2.2 percent to its lowest since 21 April 2017, as government bonds yields hit new highs, putting pressure on bank shares.
The European Commission has told Italy it is concerned about its budget deficit plans for the next three years since they breach what the EU asked the country to do in July, but Rome insisted on Saturday it would "not retreat" from its spending plans.
Italy's 10-year government bond hit fresh four and a half year highs on Monday. As a result the euro fell 0.4 percent to $1.1480, close to its lowest since Aug, 20.
"We are a bit surprised by the strength of the reaction in bond markets, but it appears the market is jumping to the conclusion that the European Commission will take a hardline stance when Italy submits its budget," said Mizuho rates strategist Antoine Bouvet.
Germany's 10-year government bond, the benchmark for the region, remains close to four-month highs at 0.559 percent .
Oil dropped back to $83.27 per barrel after Washington said it may grant waivers to sanctions against Iran's oil exports next month, and as Saudi Arabia was said to be replacing any potential shortfall from Iran.
For Reuters Live Markets blog on European and UK stock markets open a news window on Reuters Eikon by pressing F9 and type in 'Live Markets' in the search bar (Reporting by Virginia Furness Additional reporting by Andrew Galbraith Editing by Raissa Kasolowsky)