The Philadelphia Federal Reserve Bank said its business activity index fell to minus 7.7 in June from positive 3.9 the month before. It fell far short of economists' expectations for a rise to 6.8, according to a Reuters poll. It was the lowest level since July 2009.

Any reading below zero indicates contraction in the region's manufacturing. The survey covers factories in eastern Pennsylvania, southern New Jersey and Delaware.

The new orders index also fell, coming in at minus 7.6 from 5.4 in May, while inventories dropped to minus 8.5 from minus 5.4. New orders were at their lowest since June 2009.

Recent data has shown a slowdown in the pace of growth in the manufacturing sector amid weakness in the broader recovery, some of which has been blamed on supply disruptions following Japan's massive earthquake in March.

"This is a surprise to the downside. This doesn't seem to be a supply-chain issue only," said Yelena Shulyatyeva, U.S. economist at BNP Paribas in New York.

"Rising commodity prices, margin compression and a slowdown in China are suggesting a broader issue."

U.S. stocks briefly turned negative immediately following the release, while Treasury prices climbed and the greenback extended losses against the yen.

Separate data releases Thursday morning offered some hope the economy could soon pull out of its soft patch, with new claims for unemployment benefits falling last week, and housing starts and permits for future construction gaining in May.

The Philadelphia Fed release is seen as one of the first monthly indicators of the health of U.S. manufacturing leading up to the national report by the Institute for Supply Management and came on the heels of Wednesday's data which showed a gauge of manufacturing in New York State also contracted.