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Faster Factory Pace Backs Fed Taper As Economy Improves

Manufacturing activity in August expanded at the fastest pace in two years, offering some confidence that the American economy is finally pulling out of stall speed and making Federal Reserve tapering more likely.

The Institute for Supply Management's U.S. factory index, released Tuesday, rose 0.3 point to 55.7, the third straight month above 50, marking expansion.

"It speaks well to the recovery in manufacturing and general business activity," especially when viewed in conjunction with strong economic data from China and the eurozone, said Mark Luschini, chief investment strategist at Janney Montgomery Scott.

Orders Lead Way

Most of the ISM sub-indexes were also up, including the forward-looking gauge of new orders, which spiked 4.9% to 63.2, its best in more than two years.

"New orders were pretty darn strong," said Keith Hembre, chief economist with Minneapolis-based First American Funds. "That suggests there's demand somewhere.

The jobs gauge ticked down 1.1% to 53.3. But modest monthly movements are just "noise," Luschini said, especially since the index still points to net hiring. Economists expect Friday's employment report to show nonfarm payrolls rose by 175,000 in August.

Stocks closed modestly higher Tuesday in a volatile session, as investors mulled the economic reports and the likelihood of U.S. military action vs. Syria.

The 10-year Treasury yield rose 7 basis points to 2.85% on Syria relief and data supporting a likely Federal Reserve decision to begin reducing bond buying, perhaps at this month's policy meeting.

"It's another input that suggests that if we were on the path of tapering then this is evidence they are making the right choice," Luschini said.

Yet Hembre thinks the ISM data may be a bit too optimistic. Other economic data, such as regional factory reports, confidence numbers, and durable goods, have all softened, he pointed out. Some of the ISM index's increase may be attributed to more robust growth abroad: The export gauge rose 2% to 55.5.

Hembre expects the national ISM figures to moderate back to the trend set earlier in the year in the coming months, while Luschini anticipates continuing growth through the end of 2013.

The prices paid index jumped 5% to 54, still within a comfortable range, said Hembre. Price increases probably are due to rising energy costs, Luschini said. He added that while the gain merits watching closely, it's possible that it's just transitory.

The Fed is predisposed to begin tapering the economic stimulus, even if indicators like Friday's employment report come in weak, Hembre said. "If anything, these numbers work to enhance the notion that tapering should begin," he said.