A gauge of regional manufacturing activity slumped to a near two-year low in June, suggesting U.S. factories were faltering, overshadowing better than expected readings on the labor and housing markets.

The Philadelphia Federal Reserve Bank said on Thursday its business activity index dropped to -7.7, the lowest level since July 2009, from 3.9 in May.

Economists had expected the gauge of factory activity in the Mid-Atlantic to rise to 6.8 and none of the 55 participants in the poll had expected a reading lower than zero, which indicates a contraction in activity.

Coming on the heels of a survey on Wednesday showing a contraction in factory activity in New York state, the report could stoke fears of a sharp slowdown in manufacturing, a sector that has powered the U.S. economic recovery.

Factory activity is being hampered by supply chain disruptions following the March earthquake and tsunami in Japan.

The Philadelphia Fed report contradicted other data on Thursday that had offered some hope the economy could be starting to pull out of its soft patch.

There is some improvement in some series, but the manufacturing series seem to be deteriorating further in June, said Christopher Low, chief economist at FTN Financial in New York.

Initial claims for state unemployment insurance slipped 16,000 to 414,000, the Labor Department said, suggesting the jobs market was regaining some momentum after stumbling badly in May.

A report from the Commerce Department showed groundbreaking for homes rose 3.5 percent to an annual rate of 560,000 units, retracing almost half of April's steep decline. New building permits unexpectedly rebounded 8.7 percent to the highest level since December.

The housing and claims reports offered at least a hint the economic slowdown that started as the year began could be easing.

U.S. stocks fell on the manufacturing data, while prices for Treasury debt rose, also boosted by safe-haven flows on concerns Greece could default on its debt.

The broader theme we have to look at is that the pace of job destruction is slowing but the pace of job creation is also a bit tepid, said Ian Pollick an economic strategist at TD Securities in Toronto.

A report earlier this month showed U.S. employers added a scant 54,000 workers to their payrolls in May, with the jobless rate rising to 9.1 percent.

LEVELS STILL DISMAL

While both the jobless claims and housing data moved in a better direction, the levels suggested the recovery remains quite weak.

Initial jobless claims remained above the 400,000 level for a tenth straight week. Economists say claims would need to drop below that level to offer a clear sign of an improving labor market.

At the same time, economists have been largely dismissive of moves in U.S. housing data because construction and sales have moved to historically low levels.

A Reuters poll found that economists expect the housing market to sink further this year before prices start rising only marginally in 2012, a Reuters poll predicted.

Home prices -- as measured by Standard & Poor's 20-City Composite Home Price Index -- will fall 5.0 percent in 2011 and rise just 0.5 percent in 2012, according to the poll.

An oversupply of homes on the market, especially foreclosed properties which sell well below their value, has dampened construction and weighed on prices. A survey on Wednesday showed sentiment among home builders at its lowest level in nine months in June.

Data firm RealtyTrac said on Thursday that the number of U.S. homes seized by banks fell in May, but it pinned that decline on processing delays. Banks took over 66,879 homes last month, down 4 percent from April.

Groundbreaking for both multi- and single-family homes rose in May, with permits lifted by a 23.2 percent surge in the multi-family segment. The increase in multi-family units reflects a growing demand for rentals as relentless home price declines encourage Americans to delay home purchases.

GLIMMERS OF LABOR MARKET HOPE

The report on jobless claims showed the number of Americans who continued to receive benefits under regular state programs after an initial week of aid eased to 3.68 million from 3.70 million in the week to June 4, the latest week for which data is available.

Under all benefit programs, including emergency benefits extended by Congress, 7.4 million were on the rolls in the week ended May 28, down about 200,000 from a week earlier.

The data suggested the long-term unemployed were finding it somewhat easier to find jobs, although if May's dismal pace of job creation continues their hopes could be dashed anew.

(Additional reporting by Pedro Da Costa in Washington and Emily Flitter in New York; Writing by Lucia Mutikani and Tim Ahmann; Editing by Andrea Ricci)

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