Washington's budget debate could stir up new anxieties as markets head into March, even with expected reassurances about Federal Reserve policy from Chairman Ben Bernanke in the week ahead.
Bernanke is expected to soothe markets with a reaffirmation during Congressional testimony Tuesday and Wednesday that the Fed will keep policy easy as long as needed. But, at the same time Congress and the White House are likely to do battle publicly about the "sequester" spending cuts, elevating once more the view that political leaders have created an atmosphere of dysfunction.
To stop the "sequester," or $85 billion in annual automatic spending cuts, from taking effect on March 1, the issue has to be resolved in the coming week. But Wall Street is now betting chances are slim that politicians come together in a compromise, and they are likely to stretch out their wrangling, allowing the cuts to take place for a period of time.
"It will be the first time in a long time that we actually cut spending," said Daniel Greenhaus, global market strategist at BTIG. "There's a difference between is it a positive and does the market rally on it."
Greenhaus said the spending hit for the balance of the fiscal year would be $44 billion, and economists predict impact on GDP would be around a half percent reduction this year. Half the cuts would be in defense spending.
Greenhaus said Washington could continue to unsettle the markets as the month of March wears on, and Congress gets closer to a budget deadline March 27. He anticipates Congress will fail to come up with a budget in time, and the government could shut down. "My feeling was that February and March would not be as easy (for markets) as January," he said.
(Read More: 5 Reasons Not to Fear the Dreaded Sequester)
J.P. Morgan chief U.S. equity strategist Thomas Lee, one of Wall Street's more bullish analysts, raised warnings about the market in his commentary Friday. He thinks the market has entered a riskier period, and that investors may temporarily want to fade strength. The sequester discussion is one reason, and he is concerned that if the real impact on the economy is worse than economists expect, the market reaction will be very negative.
"I just think the market is not really well-equipped to handle bad news because we've become so bullishly positioned," he said. Lee is looking for a better entry point at S&P 1400 to 1450, but he is still constructive on the market.
(Read More: Pimco's Gross: Fed Not Vigilant Enough)
Stocks were mixed in the past week, with the S&P 500 ending at 1515, down 0.3 percent for the week, even with Friday's rally. It was the first down week in seven for the S&P. The Dow managed to close right on the psychological 14,000 mark, with a gain of 0.1 percent for the week, but the Nasdaq was down nearly 1 percent at 3131.
Citigroup's Tobias Levkovich, in a note Friday, also said Washington is a reason for concern. "Given potentially bitter fiscal policy battles linked to required tax and spending reforms in March, we expect some volatility in the next few weeks," he wrote.
Lee said there are a number of other reasons for caution, including headwinds for the consumer. The impact of higher payroll taxes has not been realized yet because some companies were still adjusting paychecks in February. "So we really won't know the full effect until the March retail sales," he said.
There are a group of retailers reporting earnings in the coming week, and their comments could reveal some consumer reaction to both higher taxes and gasoline prices. Retailers reporting earnings include Home Depot, TJX, Target, Best Buy, Barnes and Noble, Gap, Limited Brands, Dollar Tree, JC Penney and Saks.
Europe could also come back into play, as currency traders are focused on the outcome of the Italian election. The fear is that the race will end with a fractured result, with no one party a clear enough winner to form a government, said Vassili Serebriakov, foreign exchange strategist at BNP Paribas.
"That's the worst case scenario but that's obviously the risk is out there, and a lot of market participants are aware of it," he said, adding it made for nervous trading in the euro Friday. The election results could be known Monday, after two days of voting.
"We actually think the euro is a pretty good buy at current levels once the political dust settles. We think the highest probability is that we get a government that is center left, plus (Italian premier Mario) Monti," he said. Serbriakov sees very little chance that former Prime Minister Silvio Berlusconi's party wins but he could become a spoiler.
Nomura's Jens Nordvig said he expects a big reaction in the euro if there is not a centrist party win. The election is being eyed across markets, as the euro and Europe led the decline in risk markets this past week.
"This is potentially the most important election of the year," said Nordvig, head of G-10 currency strategy at Nomura. "I think the risk is low that Berlusconi is going to win but the centrist parties have competition both from the right, Berlusconi's party, and the Five Star anti-European movement on the left. It's got 20 percent support now. Those two things together mean for the upper house, there's a high risk, close to 50-percent that the centrist parties will not have a majority."
The Five Star party opposes Europe and the austerity measures governments have been forced to take.
Also big for currency markets is the anticipated appointment of a a new head for the Bank of Japan in the coming week. The candidate is expected to be dovish.
Serbriakov said one reason he favors the euro is because unlike the U.S., U.K. or Japan, the European Central Bank is not following easy policies that weaken its currency. The ECB is not participating in the global currency wars. "It seems the ECB is not joining in and in fact it's actually shrinking its balance sheet," he said.
The British pound and U.K. market will also be watched Monday for reaction to Moody's downgrade of U.K. domestic and foreign currency bond ratings. Moody's stripped the Triple-A rating, cutting it by one notch to Aa1. Sterling fell in late trading Friday.
In the past week, the Fed added to "risk off" mood in markets with the release Wednesday of the minutes of its January meeting. For a second month, the minutes showed that some members are concerned about the impact of Fed asset purchases, which are ballooning the Fed balance sheet. The Fed is buying $85 billion in Treasurys and mortgage each month, though the Fed members also saw the program as effective. QE is credited with keeping interest rates low while driving investors into riskier assets, like stocks and commodities.
While many Fed watchers did not see a change in the Fed's message, the markets took the comments as hawkish. So Bernanke's semi-annual testimony on the economy before a Senate committee Tuesday and a House committee Wednesday will be closely watched.
"There's nobody like Bernanke, who can bring the dovish message home," said Serebriakov. "This might be an opportunity if they feel that markets have misinterpreted their discussion a little bit."
Congress is expected to ask Bernanke how the Fed will wind down its bond buying program, another longer term worry for markets. Bernanke is expected to reassure markets that the Fed will continue its program into next year.
St. Louis Fed President James Bullard, on CNBC Friday, confirmed the Fed's position on easing and spoke directly to some of the concerns raised by the minutes. Bullard is known to be somewhat hawkish and has said he thinks the Fed should slow down or stop its purchases as the economy improves.
"Fed policy is very easy, and it's going to stay easy for a long time. I think that's my main message this morning," Bullard said on "Squawk Box."
Read More: (Fed's Bullard: Policy to Stay 'Easy' for 'Long Time')
Bullard said the Fed's easing program carries a "punch" and markets have not yet felt the full impact of the Fed's additional Treasury purchases. The Fed last December transformed a program where it bought long dated Treasurys and sold the same amount of securities at the short end, into a program where it just buys Treasurys. Bullard also spoke to the Fed's discussions on the anticipated end of its program.
"It's true the committee is thinking about how we're going to handle this later this year," he said. "But that's a natural thing for the committee to be talking about."
What to Watch:
Earnings: Lowe's, Autodesk, Oneok, Caesar's Entertainment, Health Care REIT, Stifel Financial, FirstEnergy
1030 am Dallas Fed survey
0100 pm $35 billion 2-year notes auction
0700 pm Atlanta Fed President Dennis Lockhart speaks on economy
Earnings: Home Depot, AutoZone, Saks, Macy's, Bank of Montreal, Holly Frontier, American Tower, Priceline.com, Vornado Realty, First Solar, American Water Works, Edison International, Tivo, Papa John's, AMC Networks, Vivendi, Tenet Healthcare, Sempra Energy, Range Resources, MetroPCS
0900 am S&P/Case-Shiller home prices
1000 am Fed Chairman Ben Bernanke testifies on economy before Senate Committee
1000 am New home sales
1000 am Consumer confidence
1000 am Richmond Fed survey
0100 pm $35 billion 5-year notes auction
Earnings: AB InBev, Target, Dollar Tree, JC Penney, Groupon, Limited Brands, TJX, Continental Resources, Mylan Labs, Monster Beverage, Joy Global, NRG Energy, Federal-Mogul, Whiting Petroleum, Pall, Liberty Media, Chicago Bridge and Iron, DCP Midstream Partners. Vale, Liberty Brands, Western Gas Partners, Liberty Media, Liberty Interactive, Federal-Mogul, CenterPoint
0830 am Durable goods
1000 am Bernanke testifies before House Committee
1000 am Pending home sales
0100 pm $29 billion 7-year note auction
0430 pm Dallas Fed President Richard Fisher speaks on economy
Earnings: Kohl's, Best Buy, Barnes and Noble, Sears, Gap, Salesforce.com, Luxottica, Ocwen Financial, Rowan Cos, Western Refining, Copano Energy, Great Plains Energy, Cablevision, Chico's FAS, Domino's Pizza, Sotheby's, Universal Health, Toronto Dominion, Canadian Imperial Bank, Iron Mountain, Valeant Pharma, Integrys, Molycorp, Splunk
0830 am Initial claims
0830 am Q4 GDP (second)
0945 am Chicago PMI
1100 am Kansas City Fed
Earnings: Foster Wheeler, Magna International, Pepco Holdings, Berkshire Hathaway
Monthly auto sales
0830 am Personal income
0858 am Markit Manufacturing PMI
0955 am Consumer sentiment
1000 am ISM manufacturing
1000 am Construction spending