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.