U.S. employers cut a deeper-than-expected 263,000 jobs in September, fueling fears the weak labor market could impede the economy's recovery from its worst recession in 70 years.

The 21st straight monthly decline in non-farm payrolls helped to lift the unemployment rate to a 26-year high of 9.8 percent from 9.7 percent in August, according to a Labor Department report.

While the contraction in employment was worse than the 180,000 drop economists surveyed by Reuters had predicted, many believed it did not signal the start of a reversal in the trend toward stabilization of the labor market.

Some analysts even suggested September's reading might have been distorted by a sharp drop in government employment.

I don't think it argues against a modest recovery in the U.S. economy ... but this is why we are not in a rapid V-shaped recovery. September was the payback month, Stuart Hoffman, chief economist at PNC Financial Services in Pittsburgh.

U.S. stocks opened lower on the data, but clawed back most of the losses on buying in technology and financial shares. Shares slipped this week as other data pointed to a leveling-off in the nascent U.S. recovery from a recession that began in December 2007.

U.S. Treasury prices rallied initially but then gave up those gains. Bond market investors are wary after a recent rally in U.S. government debt -- considered a safe investment weak economic times -- that has brought the benchmark 10-year note to its lowest yield since May.

For graphics on the jobless rate and payrolls, see http://graphics.thomsonreuters.com/109/US_UNEMPL1009.gif

BAD NEWS FOR OBAMA?

The jobless numbers might be bad news for U.S. President Barack Obama's attempt to reform the U.S. healthcare system, as Congress will want to limit spending on a health sector overhaul if the economy is taking longer to recover.

While Obama's overall approval ratings have stabilized at 50 percent or above since August, deepening unemployment could drag them down and polls continue to show significant opposition to his handling of healthcare.

Vice President Joe Biden described the employment report as tough news and appeared to indicate the economy, which received a $787 billion spending package this year, might not need a second stimulus package.

We are still working on finishing the first one and doing it right. We also know all along that the recovery was going to take a long time, Biden told reporters at the White House.

The government revised job losses for July and August to show 13,000 more jobs were lost than previously reported.

Stubbornly high unemployment is viewed as the missing link in recovery from the longest and deepest slump since the Great Depression of the 1930s. The economy is believed to have started growing in the third quarter.

Since the start of the recession, the number of unemployed people has soared 7.6 million to 15.1 million, the department said. While the pace of job losses has moderated from early this year, companies are still not hiring on a big scale, likely waiting for a signal that the recovery is sustainable.

STILL ON TRACK FOR RECOVERY

We're probably still on track for recovery, but it's going to take time to unfold, said Gary Thayer, strategist at Wells Fargo Advisors in St. Louis, Missouri.

The trend is still improved from earlier this year, but employers need to feel more confident about the economy before they start hiring again.

Manufacturing employment fell by 51,000 in September, while construction industries payrolls dropped 64,000. The service-providing sector cut 147,000 workers in September, while goods-producing industries shed 116,000 positions.

Education and health services added a mere 3,000 jobs, while government employment fell 53,000 -- reflecting cutbacks by state and local governments, many of which are facing accelerating fiscal problems.

Even more concerning, a gauge of labor market slack that measures both the officially unemployed and discouraged job seekers rose to a record 17 percent in September from 16.8 percent in August. The report also showed 5.4 million people had been unemployed for more than six months.

Still some economists are unperturbed by the poor September employment report.

We are more inclined to view September as a temporary setback than as a signal that the decelerating trend in job losses has stalled out, said Stephen Stanley, chief economist at RBS in Greenwich Connecticut.

The anecdotal and survey evidence as well as the claims data point to continued progress toward stabilization, though the path remains painfully slow.

The average workweek, which closely correlates with overall output and gives clues on when firms will start hiring, dipped to 33 hours from 33.1 in August, the data showed.

Average hourly earnings inched up to $18.67 from $18.66.

Separately, new orders received by U.S. factories posted their first drop in five months in August, a Commerce Department report showed on Friday.

(Additional reporting by Lisa Lambert and David Alexander in Washington, Ellen Freilich in New York; Editing by Neil Stempleman)

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