Friday's jobs number is the next big hurdle for markets, and traders expect it to be pivotal to the Fed's next easing move, as well as a factor in whether the stock market can continue to rally.
Stocks on Wednesday roared higher on stronger U.S. and Chinese manufacturing data, the first bright spot in the U.S. economic data stream in quite awhile. The Dow jumped 254 points to 10,279, and the S&P 500 was up nearly 3 percent at 1060, after theISM manufacturing survey, at 56.3, beat expectations and surpassed July's 55.5 level.
"The ISM is a reassuring sign. It says that although some of the data has been weaker of late, you are not seeing the kind of downward spiral that would precede a recession or sharp slowdown...It is one of the more reliable indicators that we have because it's not revised. It's a survey. Historically, it's proven to be a good indicator," said Barclay's Capital chief U.S. economist Dean Maki.
Maki does not expect the number to have much bearing on the August employment report, though the ISM employment index was at a 27 year high, reflecting an improved pace of manufacturing hiring over the last several months.
"You did see new orders fall so we do think there's some slowing to come in manufacturing output, but what this really tells us is the fears of a sharp slowdown or double dip have been overdone, and we are continuing to be in a moderate recovery. You don't get a reading of 56.3 when the economy is spiraling downward," he said. Any reading over 50 in the ISM indicates growth.
While Thursday has several important economic reports, traders are focused on Friday's August employment report, which is expected to show an increase in private sector jobs of just above 40,000. Maki expects the private sector added 60,000, down from July's 71,000. He expects non farm payrolls to be negative 70,000, including the loss of 115,000 temporary govenrment census workers and another 15,000 state and local government employees.
Thursday's calendar includes weekly jobless claims and productivity and labor costs, at 8:30 a.m. Factory orders and pending home sales are at 10 a.m. Chain stores report August sales, which are expected to show a soft back-to-school shopping season. Thomson Reuters expects sales of stores in its index to be up 2.5 percent.
There is also a heavy dose of Fed speak Thursday, including testimony by Fed Chairman Ben Bernanke before the Financial Crisis Inquiry Commission at 9 a.m. FDIC chair Sheila Bair also speaks before the panel.
Boston Fed President Eric Rosengren and Cleveland Fed President Sandra Pianalto both speak in Washington at a summit on foreclosed and vacant properties. Outgoing Fed Vice Chairman Donald Kohn spoke to CNBC's Steve Liesman and his exclusive interview will continue to air on Squawk Box, starting at 7 a.m.
As stocks ripped higher Wednesday, bonds sold off, and the 10-year yield rose above 2.6 percent at one point. It was at 2.582 in late afternoon trading. The stock market, widely expected by strategists to struggle through September and October, saw its best start for a September since 1998. There was plenty of chatter on both bond and stock desks about major asset allocation changes driving the moves in bonds and stocks.
"Even though we've been looking for a correction, it's too early to claim victory," said RBS Treasury strategist John Briggs, noting that bonds are at levels that have lured in buyers.
"This ISM, being top tier data, with the employment component at the highest since 1983...it opens up the possiblity that the (bond) market could be traded two ways," said Briggs. Bonds prices have been rising as stocks slumped in one of the worst August performances in nine years.
The jobs report will be key. "I think this one is more important than the last few. The Fed's on edge. They're data dependent because we're data dependent...If this number is really good, it sets the tone for the next few weeks and sets a range for the bond market.
If it's awful, it opens the door for whether the Fed does quantitative easing," he said. The third choice is "plodding along' and plodding along is not good enough, but it might be good enough to hold off quantitative easing for another month."
The Fed has indicated it could expand its Treasury purchase program to drive down rates. It currently is buying Treasurys with the proceeds from the maturing mortgage securities in its portfolio, in an effort to keep its balance sheet steady.
Stock traders, meanwhile, said they saw healthy buying demand along with some short covering Wednesday. Financials and industrials were the best gainers, up about 3.9 percent.
Steve Massocca, managing director at Wedbush Securities, said he expects to see some follow through Thursday. But the market still needs another catalyst.
"I think we're washed out. I don't think you're going to see the market get below 1040 on the S and P, but I don't think you get above 1100 either. You need something definitive to happen," he said.
Traders Wednesday were also speculating about the possibility that Democrats, facing a tough mid-term election, could change their views on extending the Bush tax cuts. If the cuts were extended across the board, they believe it would be a positive for stocks.
"One logical surmise from the policital surveys is that the Administration is going to take a more centrist tone, that is mabye more amenable to business," said one trader.
In the foreign exchange market, the dollar lost nearly a percent against the euro Wednesday, but gained a half percent against the yen.
"The dollar/yen is going to be a yoyo, very much dependent on how U.S. data prints," said Boris Schlossberg of GFT Forex.
Schlossberg said he is watching the European Central Bank which holds a rate meeting early Thursday. "I think (ECB President Jean-Claude) Trichet is going to pat himself on the back because data out of the Eurozone has for the most part shown improvement. You can make a case that there's some decoupling between the U.S., Asia and Europe, and Germany is a beneficiary of strong demand out of China," he said.
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