GLOBAL MARKETS-Stocks rally on Wells-Wachovia deal, dollar gains

*U.S. stocks rally, dollar gains on European weakness

*Wells Fargo buying Wachovia for $15.1 bln

*U.S. job rolls suffer deepest cut in 5-1/2 years in Sept

By Daniel Bases

NEW YORK, Oct 3 (Reuters) - U.S. stock markets rose on Friday after a $15.1 billion merger deal between Wells Fargo & Co (WFC.N) and beleaguered Wachovia Corp WB.N, overshadowing the biggest drop in U.S. payrolls in 5-1/2 years.

The U.S. economy lost 159,000 non-farm jobs last month. Employment contracted for a ninth straight month, even before the labor market experienced the full shock from September's series of bank troubles.

A deteriorating financial backdrop in Europe is giving a sustained lift the U.S. dollar even as America's economy is working its way through the financial turmoil and economic slowdown.

"We've seen weaker data in history, but these look pretty decisively to be the beginning of something worse," said Pierre Ellis, senior economist with Decision Economics Inc in New York.

That worse-than-expected jobs report could tip the balance for the U.S. House of Representatives to vote for an historic $700 billion rescue package for banks and other financial firms burdened by bad mortgage-related assets, which is contributing to a global credit crunch. An earlier attempt failed on Monday, sending stocks careening lower.

"Realistically, the focus is on the Wells Fargo-Wachovia deal. (US Treasury Secretary Henry) Paulson's been saying all along he wanted to get private markets involved again," said Justin Wiggs, equities trader at Stifel Nicolaus Capital Markets in Baltimore.

"Also, all indications suggest (the bailout bill) is gaining speed in the House, which is important, because if it doesn't pass, it could get ugly," he added.

The banking merger news gave a shot of optimism to investors that business was still getting done in the financial industry. Wells Fargo's deal scuttled Citigroup's attempt to buy Wachovia's banking assets for $2.16 billion in a government brokered deal.

In the first 30 minutes of trade in New York, the benchmark Dow Jones industrial average .DJI was up 141.13 points, or 1.35 percent, at 10,623.98.

The Standard & Poor's 500 Index .SPX was up 22.47 points, or 2.02 percent, at 1,136.75. The Nasdaq Composite Index .IXIC was up 43.81 points, or 2.22 percent, at 2,020.53.

European share prices rose ahead of the U.S. market open after the merger news and held their levels.

The FTSEurofirst 300 index .FTEU3 was up 1.4 percent on the day while MSCI main world equity index .MIWD00000PUS erased earlier losses to rise 0.71 percent.

Japan's Nikkei 225 index .N225 fell 1.9 percent to a three-year closing low on Friday for its worst week in more than a year. The Wachovia deal was announced after Japan's markets closed.

Government bonds fell on the increased risk tolerances.

Benchmark 10-year U.S. Treasuries fell 13/32 of a points in price, pushing the yield up to 3.67 percent US10YT=RR.

U.S. rate futures fully price in a 50 basis point cut to the Oct 28-29 Federal Open Market Committee meeting, to 1.5 percent -- similar expectations from late on Thursday.

In the euro zone, government bond futures pared gains as a result of the U.S. stock market rally too. The liquid two-year Schatz yield EU2YT=RR, which is sensitive to moves in equity markets, was flat at 3.273 percent

DOLLAR RALLY

Europe's weakening economy prompted the European Central Bank on Thursday to open the door for its first interest rate cut in more than five years.

ECB President Jean Claude Trichet said inflation risks have eased as financial market turbulence hit the euro zone.

A cut in Europe's benchmark interest rate would erode the attractiveness of the euro, which fell 0.54 percent in early New York trade to $1.3744 EUR=.

The U.S. dollar is on track for its biggest weekly gain in 16 years, up 0.37 percent on the day and holding near a one-year high against a basket of major currencies .DXY,

A softening of the commodity markets also eased up the negative pressure on U.S. stocks but spelled bad news for emerging markets which derive much of their economic strength from the export of precious metals, grains and energy.

Emerging sovereign spreads 11EMJ widened one basis point while emerging stocks .MSCIEF lost 1.31 percent, rising from an earlier two-year low.

Spot gold prices XAU= fell $6.80 or 0.81 percent to $828.20 an ounce.

U.S. light crude CLc1 fell 0.2 percent to $93.78 a barrel. (Additional reporting by Ellis Mnyandu, John Parry, Nick Olivari in New York; Ros Krasny in Chicago; Glenn Somerville in Washington; Natsuko Waki, George Matlock in London)