Political sideshow could preoccupy US markets

Traders on the floor of the New York Stock Exchange.
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Traders on the floor of the New York Stock Exchange.

Stocks on Wall Street could flounder again Wednesday as traders watch the political sideshow in Washington and prepare for quarter end.

"I think the last four days are really telling us that something has changed in the market," said Peter Boockvar, chief market analyst at the Lindsay Group. "Something's changed. I just think we pushed the spread between the underlying fundamentals in the stock market too far from asset prices."

(Read more: Spending showdown averted for now)

Stocks sagged Tuesday after a squishy performance Monday. The Nasdaq was the bright spot, up 2 points at 3768, while the Dow fell 66 points to 15,334, and the S&P 500 slid 4 points to 1697. Treasurys rallied, with the 10-year yield moving to 2.65 percent.

"The Fed gave every bull what they wanted – more easing – but stocks haven't cooperated," said Boockvar. The Fed surprised markets last Wednesday when it held back from slowing down its $85-billion-a-month bond buying program on concerns financial conditions and the economy aren't strong enough. The Fed also pointed to fiscal uncertainty.

"This is the first time in a while the market didn't go up on a gift from the Fed," Boockvar said. "The market set up a tee for them to hit the ball, and they blew it. They were tone deaf to the market." Boockvar said the market could now react to a sluggish economy and not-so-good earnings.

Gabe Mann, RBS Treasury strategist, said the Fed's inaction has also changed the bond market. He said the 10-year Treasury yield, which moves inversely to price, is set up for a move lower after breaking the key 2.67 percent level Tuesday.

"The Fed skewed more dovishly than people expected. Guys were very short the market. The announcement of tapering would have confirmed some of that sentiment," he said. Now the market is dialing back and he expects to see the 10-year yield move to the 2.45 percent zone. "We might be out of consensus with that kind of target but (the market) today gave us a little more information about the path of rates."

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While many strategists do not expect the government to shut down, Mann said he is monitoring the moves by Congress as it considers legislation to keep the government funded past Sept. 30 with a temporary extension. It will then debate raising the debt ceiling, which Republicans oppose and President Obama has said is not negotiable. Treasury Secretary Jack Lew says it is necessary in order to fund expenditures already approved by Congress. At a conference Tuesday, Lew said the U.S. has less cash on hand than anticipated and that the ceiling would be hit in mid-October.

The House is back in session on Wednesday , and the Senate is expected to reject a measure approved by the House Friday that would fund the government temporarily but would also defund Obamacare.

President Obama's twitter account Tuesday tweeted a story by CNBC's Steve Liesman based on his All America Economic survey. The survey showed a majority of Americans oppose defunding Obamacare if it means shutting down the government or defaulting on the debt.

Republican leaders in the Senate do not support the House bill to defund Obamacare, and the Senate is expected to consider over the weekend a bill that addresses just the continuing resolution to fund the government. Congress will then have Sunday and Monday to come to a meeting of minds or the government will shut down.

"If investors thought we were going to have a shutdown for any length of time, the market would have been selling off harder than it has been," said Mark Luschini, chief investment strategist at Jefferies.

Many analysts think Congress will pass the spending resolution and save the worst of its bickering for the debt ceiling, which will be a more difficult battle for markets to watch.

"I think stock investors are somewhat de-sensitized because of what they went through last November and December," said Boockvar. "They were all worked up over the fiscal cliff and it ended up being nothing, so in my opinion, it's all about the Fed."

Because of the Fed, traders are hyper-focused on economic data. Wednesday's reports include durable goods at 8:30 a.m. and new home sales at 10 a.m. The Treasury will auction $35 billion worth of 5-year notes at 1 p.m. Durable goods, while volatile, will be important.

(Read more: Will Obama shake hands with Iran's president at UN?)

Durable goods are expected to be down 0.5 percent, after July's surprise 7.4 percent decline.

"I'm looking at the core capital goods orders because to me that's business spending," said Luschini. "Out of the five previous months, we've had four showing improvement. Was last month an aberration or a pattern?"

Oil Drill

Investors will continue to focus on the United Nations, where six nations were expected to meet with Iran on the sidelines of the meeting to see if negotiations about its nuclear program will resume. President Barack Obama spoke at the UN and said he directed Secretary of State John Kerry to pursue negotiations. Iranian President Hassan Rouhani said he could come to a framework to "manage our differences" with the U.S.

Expectations were high that Obama and Rouhani would have a casual meeting Tuesday, and perhaps the two leaders would shake hands, a symbolic gesture after 34 years of chilled relations. But Rouhani and the Iranian delegation did not show up at a lunch Obama was attending, nor did they meet in the hallways. Senior Administration officials told White House reporters that the meeting proved "too complicated" for Rouhani back home.

"I think that was putting the cart before the horse that people were expecting that," said Addison Armstrong of Tradition Energy. Crude did climb off its lows in afternoon trading. "I don't think the rebound we saw in crude had anything to do with the lack of any greeting. We bounced today because the Brent/WTI spread got too wide…I don't think there was the impression in the oil market today that anybody was snubbed."

(Read more: Showdown at DC corral only a short-term fix)

Kerry's meeting with his Iranian counterpart will be the highest level encounter between the two governments in six years.

Oil continued to weaken Wednesday with West Texas Intermediate hitting an eight-week low of $103.13 per barrel. Oil inventory data will be released at 10:30 a.m. ET. "The thing we'll be watching closely is how much capacity utilization comes out of the refinery numbers, and of course products have gotten cheap so the question is why are we running a high level of capacity utilization," he said.

The national average for a gallon of unleaded gasoline was $3.46, down from $3.51 a week ago, according to AAA.

—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.