A string of better data sent stocks rallying and bond yields higher Thursday, as investors pared back their Treasury holdings in anticipation that the July employment report could also be better than expected.
Stocks soared to new highs, with the S&P 500 rising above 1,700 for the first time to close 21 points higher, at 1,706. The Dow jumped 126 points, to a record 15,626. Meanwhile, the 10-year yield moved sharply higher, from 2.6 percent in the morning into a range that could start to make stock traders nervous. The 10-year yield was at 2.72 percent in afternoon trading.
Weekly jobless claims Thursday fell more than expected to 326,000, the lowest level in over five years. July's ISM manufacturing survey rose a surprising 4.5 points, to 55.4, the highest reading in 13 months and the biggest one-month increase since 1996.
(Read more: Jobless claims touch 5 1/2-year low)
Though just one month's number, ISM at that level would be consistent with GDP growth above 4 percent—well above the 1.7 percent growth rate in the second quarter and way above what economists expect. The ISM employment component rose to 54.4 after dropping to 48.7 in June, for the strongest reading in more than a year. A number over 50 shows expansion, and ISM had fallen to 49.9 in May, a four-year low. The U.S. data came after reports of improved manufacturing confidence in the euro area, the U.K. and China.
"It does look like the manufacturing sector will do better," said Dean Maki, Barclays chief U.S. economist. "Last month, manufacturing lost 6,000 jobs and it lost jobs for the last four months, so today's number would suggest that should turn into positive territory."
Maki expects to see 175,000 new payrolls. "Things don't always line up between ISM and job growth, so it suggest in the third quarter we'll move back into positive territory. We would expect to sees some increase in construction, but the big driver will be the services sector. The government sector will have lost some jobs."
Stephen Stanley, chief economist at Pierpont Securities, said the fact that automakers did not shut plants as they normally do in July may have affected the ISM number.
"I guess I'm a little skeptical, but the ISM when the production index is way over 60—the economy doesn't feel that strong," he said. "The various data would support an ISM number in a low-to-mid-50s, not like the one we saw today. That was a one-off." The production index component rose more than 11 points to 65, the highest level in nine years.
Stanley also expects to see 175,000 net jobs in July, but 205,000 before counting public sector layoffs.
While always important, the monthly employment report has taken on heightened significance because jobs are a key metric the Fed will use in deciding whether to pull back from its quantitative easing program. The Fed is widely expected to start reducing its $85 billion a month bond-buying program in September if the economic data is strong enough, and Friday's report is one of two employment reports between now and its next meeting.
Maki said 175,000 total jobs would be enough to keep the Fed on track for a September reduction in bond purchases, which the central bank says has suppressed interest rates.
"This would be firm enough in our view to keep the Fed on track for tapering in September, especially in light of the strength in the ISM," he said.
(Read more: Too weak for Fed tapering: El-Erian)
Diane Swonk, chief economist with Mesirow Financial, said the Fed must weigh August data as well.
"We need more than one month," she said. "They'll still have the August employment report to look at. The debate on tapering is a much more nuanced debate. The debate is should the Fed being doing more for the economy."
The Fed also runs the risk that improving data along with its tapering program could send interest rates higher too quickly. In its post-meeting statement Wednesday, the Fed pointed for the first time to the risk to the housing recovery from rising mortgage rates.
Swonk expects 220,000 jobs for July, and she said the type of jobs being added will be higher quality, including more manufacturing and construction.
"The downfall could be some defense-related," she said. "There are furloughs going on in defense right now, and that's hard to track in the employment data. I think we're in a situation to have a better composition of jobs this month, and that's the good news. The bad news is we're not sure it's going to continue—and it needs to continue a lot."