Wall Street falls on North Korea nuclear test, U.S. rate hike worry

By Chuck Mikolajczak

NEW YORK (Reuters) - U.S. stocks dropped on Friday as investors were rattled by a nuclear test by North Korea and comments by Federal Reserve officials that hinted at a U.S. interest rate hike, putting the S&P 500 on pace for its worst day in over two months.

North Korea conducted its fifth and biggest nuclear test on Friday and said it had mastered the ability to mount a warhead on a ballistic missile, drawing condemnation from the United States as well as China, Pyongyang's main ally.

There was further pressure on the equity market after Boston Fed President Eric Rosengren, a historically dovish policymaker, said the U.S. central bank faced increasing risks if it waited too much longer. He said a gradual monetary policy tightening was likely appropriate, although he added the Fed was unlikely to raise rates too rapidly.

"This is more about central banks than anything else; there's a rising expectation of inflation as well as what seems to be a modest shift within central banks for a little bit steeper yield curve," said Jason Pride, director of investment strategy at Glenmede in Philadelphia, which manages more than $30 billion in assets.

But Fed Governor Daniel Tarullo, also a voting member, was more cautious and said on Friday in an interview with CNBC he wanted to see more evidence of U.S. inflation rising back toward the Fed's 2 percent target, although he would not discount the possibility of a hike this year.

The Dow Jones industrial average fell 230.86 points, or 1.25 percent, to 18,249.05, the S&P 500 lost 31.38 points, or 1.44 percent, to 2,149.92 and the Nasdaq Composite dropped 80.92 points, or 1.54 percent, to 5,178.57.

The Fed will hold a two-day policy meeting on Sept. 20-21. The perceived chances of a September rate hike climbed to 24 percent in the wake of the Fed comments, according to CME's FedWatch tool, from 18 percent the previous day.

Utilities and telecoms were both down more than 2.5 percent as the worst performing of the 10 major S&P sectors. The sectors have been strong performers on the year as investors have used their high dividends as a bond proxy.

U.S. stocks have been subdued for two months, with the benchmark S&P 500 index failing to register a move of more than 1 percent on a closing basis in either direction since July 8. The index is currently on track for its worst day since June 27.

U.S. wholesale inventories were unchanged in July as previously reported and sales fell, suggesting a limited boost to economic growth from restocking in the third quarter.

Energy shares, down 2.1 percent, also slumped as Brent and U.S. crude fell more than 3 percent after surging more than 4 percent the prior session as the market discounted an unexpected slump in U.S. crude inventories as a storm glitch.

(Additional reporting by Rodrigo Campos; Editing by Bernadette Baum and James Dalgleish)