COLUMN-Fed runs out of patience, risk rally runs out of road: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

March 6 (Reuters) - The Fed is going to run out of patience, which means the equity rally may run out of road.

Bonds, which have already had an ugly few weeks, would come in for more.

Job creation blew through expectations in February, with 295,000 positions added, as the U.S. jobless rate sank to a 6-1/2-year low of 5.5 percent. Average hourly earnings are rising at a 2 percent annual clip, slightly down from the month before but well in excess of consumer inflation.

Now (NYSE: DNOW - news) neither the trend nor the absolute numbers are consistent with zero interest rates, especially given that an unemployment rate of 5.5 percent is arguably within the zone where wages rise to attract labor.

The most likely course: the Federal Reserve moves deliberately but rapidly to make its first move upward in rates in the post-crisis era.

"We expect monetary policymakers to drop 'patient' from the communiqué following the March meeting, setting the stage for an initial liftoff in rates in June," Brian Jones, economist at Societe Generale (Paris: FR0000130809 - news) , wrote in a note to clients.

While there is still disagreement within the Fed, even John Williams of the San Francisco Fed, who is usually counted among the doves, is making impatient noises.

"Overshooting our target would force us into a much more dramatic rate hike to reverse course, which could have a destabilizing effect on the markets and possibly damage the economic recovery," Williams said on Thursday before the payrolls data was released.

"I see a safer course in a gradual increase, and that calls for starting a bit earlier."

And while markets moved to narrow the gap on Friday, there is still a startling disconnect between their expectations of the rate of ascent in rates and those of the Fed's own forecasts. Before six weeks or so ago, the market had it pretty much its own way, but if that tension is going to be resolved in favor of the central bank, as these things usually are, the clear risks for most financial assets are to the downside.

The next FOMC meeting on March 17-18, ending with an interest rate decision, statement, new forecasts and a press conference by Janet Yellen, is the most likely venue for the resolution. If the Fed drops "patience," the reality of a rate rise at the June or July meeting will be inescapable.

FINANCIAL ASSET RECKONING

Between now and March 18 we can expect the financial markets to focus not on the good news of the moderate strength of the U.S. economy but on just what more expensive money does to stocks and bonds.

Equities got a start on Friday, with the S&P 500 falling 1.5 percent, leaving it clinging to about a half a percent gain for 2015. Ten-year Treasuries sold off even more strikingly, sending yields up 13.5 basis points to 2.25 percent, a rise of more than 6 percent. Ten-year yields have risen by more than a third since Feb. 2.

If the bond market move is sustained and extended, or perhaps more to the point, if nothing dramatic happens in the economy to change the apparent direction of travel, investors are going to start to think through a markedly less friendly scenario for equities.

The strong performance of equities in the U.S. has benefited from two strong tailwinds. First (Other OTC: FSTC - news) monetary policy, up until now, has been designed to shake money out of safety and into riskier assets. Higher interest rates don't just diminish the value of the stream of future cashflows which a share in a business represents, they also change the balance between risk and return.

The second equity tailwind has been high corporate profitability, based in part on the long-term fall in the share of takings which companies have been forced to pay out in wages and compensation.

Wages may now be on the rise. Wal-Mart recently said it would spend about $1 billion raising wages and improving schedules for 500,000 of its lowest-paid employees. Others like retailer T.J. Maxx have made similar moves. The Fed's Beige Book also noted employers in the Atlanta (BSE: ATLANTA.BO - news) and Chicago Fed districts were raising wages for unskilled and entry-level workers. The number of workers voluntarily quitting is also up 12 percent year on year.

Rising wages are welcome but imply falling margins.

Falling margins and rising interest rates are an unlovely combination for riskier assets, even in a recovery. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft) (Editing by James Dalgleish)