* Jobless claims fall 27,000 to two-month low
* Trade deficit narrows to $42.8 billion in July
* Imports retreat, exports highest since August 2008 (Adds details, byline, updates markets)
By Lucia Mutikani and Doug Palmer
WASHINGTON, Sept 9 (Reuters) - New U.S. claims for unemployment benefits fell more than expected last week to a two-month low, while the trade deficit narrowed sharply in July, hopeful signs for the stuttering economic recovery.
The data on Thursday helped to calm fears of a sharp slowdown in growth and implied the economy could start working its way out of a soft patch.
"The economy is not out of the woods with today's data, but things look better than they have in several weeks and there is no danger of a new downturn in activity," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.
Initial claims for state unemployment benefits dropped 27,000 to 451,000, the lowest since the week ended July 10, the Labor Department said. That was well below financial market expectations for 470,000.
Separately, the trade deficit shrank 14 percent to $42.8 billion in July, smaller than the $47.3 billion gap that markets had expected. Analysts said that suggested the pace of economic growth would quicken in the third quarter.
Stocks on Wall Street rose on the data, while prices for safe-haven U.S. government debt slipped. The dollar hovered near a 15-year low against the yen.
The U.S. economy braked sharply in the second quarter, expanding at just a 1.6 percent annualized rate, and soft data in recent months had fueled fears of a double-dip recession.
While the most recent signs have tamped down those fears, they likely come too late for the embattled Democratic Party ahead of the Nov. 2 congressional mid-term elections.
Opinion polls suggest voters, dissatisfied with President Barack Obama's handling of the economy, could punish Democrats and hand control of the House of Representatives, and perhaps even the Senate, to Republicans.
Graphic showing U.S. trade balance:
http://link.reuters.com/had52p
Graphic on jobless claims:
http://link.reuters.com/hud52p
LACK OF JOBS UNDERMINING RECOVERY
A weak labor market has been undermining the economy's recovery from its longest and deepest downturn in 70 years, but a few rays of light are starting to poke through the dark cloud of unemployment.
Government data on Friday showed private employers added a better-than-expected 67,000 jobs in August, while 36,000 more jobs were created in July than previously reported.
Confronted with a 9.6 percent unemployment rate and potentially big losses for Democrats at the polls, Obama on Wednesday called for $50 billion in spending on infrastructure and tax breaks for businesses.
The decline in claims for unemployment benefits last week saw them push further away from a nine-month high of 504,000 touched in mid-August, a further sign of some stability returning to the labor market.
"Given the flood of soft economic data that we've seen in recent months, the continued improvement in jobless claims is encouraging as it reinforces the reversal of the negative trend that had been in place," said Jim Baird, a partner at Plante Moran Financial Advisors in Kalamazoo, Michigan.
"However, we shouldn't lose sight of the fact that the labor market is still exceptionally weak."
A Labor Department official said the department had to estimate claims data for some states that had been unable to submit data due to Monday's Labor Day holiday.
Some have since submitted their data and the official said the figures were close to the department's estimates, indicating the data was unlikely to be revised much.
TRADE SHIFT COULD LIFT GDP
The shrinking of the trade deficit was welcome news after a widening trade gap sliced nearly 3.4 percentage points off U.S. economic growth in the second quarter.
A widening trade deficit weighs on growth because it shows more domestic demand is being met by overseas production.
Economists said July's shrinking gap suggested third-quarter growth could improve on the second quarter's dismal performance.
A Reuters poll released on Wednesday showed economists were looking for GDP to expand at a 1.8 percent annual rate in the third quarter, just a fraction above the April-June pace. [ECILT/US]
The smaller trade gap reflected a 1.8 percent increase in exports to $153.3 billion, the highest since August 2008. Imports fell 2.1 percent to $196.1 billion.
However imports from both China and Germany -- two countries with persistent trade surpluses -- were the highest since October 2008.
The closely watched trade deficit with China fell almost 1 percent in July, but for the first seven months of the year it was nearly 18 percent higher, at $145.4 billion, compared to the same period in 2009.
U.S. lawmakers are expected to turn their attention to China's exchange rate practices when they return next week from their summer recess. [ID:nN08124393]
Many accuse Beijing of deliberately undervaluing its currency by as much as 40 percent to give Chinese exporters an unfair trade advantage.
(Editing by Andrea Ricci)