Washington deadline could be nail biter for 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.

With a midnight deadline hanging over Congress, stocks could be whipped by headlines from Washington Wednesday but should ultimately be able to limp through the latest drama.

Stocks fell Tuesday, ending a four-day winning streak as the Senate and House hit a seeming impasse on legislation to reopen the government and avoid hitting the debt ceiling. The House abandoned a plan to vote on any measure on Tuesday night. The Dow fell 133 to 15,0168, and the S&P 500 fell 12 to 1698.

(Read more: US debt deal: 2nd verse, same as the first)

Fitch put the U.S. on negative credit watch after the market close, noting that "political brinkmanship and reduced financing flexibility could increase the risk of a US default."

Stock futures were trading lower after the market close, and took another hit on the Fitch news. So far, Standard and Poor's is the only rating agency to have reduced the U.S. from AAA status. It did so during the last debt ceiling drama in August, 2011.

"We could see a downgrade even if we just see this stupid iron-headed process that the politicians continue to inflict on us," said Ward McCarthy, chief financial economist at Jefferies. If there is a second downgrade, "It means we probably should get a third one. When you're this fiscally irresponsible, you really don't deserve a triple A credit rating."

McCarthy said he visited Asia last week and investors there are becoming impatient. "I can attest to a frustration level that has gone from simmering to close to boiling over," he said.

The Obama Administration has warned that the debt limit will be reached Oct. 17, and Congress has been working to advance legislation by the deadline.

(Read more: House vote on GOP plan delayed as deadline nears)

House Republican efforts to avert a default and end a partial government shutdown neared collapse on Tuesday night.

"What we wouldn't want to see is this deteriorate to another standoff. That would be a real disappointment after the progress they 've made," said Gary Thayer, Wells Fargo Advisors chief macro strategist.

"There's a lot of different factions in both parties, and they all want to make sure they get their views considered," he said. "It doesn't mean they derail the whole process in the end. We're still likely to see some resolution of this by the 17th or soon thereafter. It won't be ideal but it will be a compromise…then they'll pick up the fight again in a few months."

A Senate plan floated on Tuesday had included a funding resolution to fund the government through mid-January and move the debt ceiling issue to Feb. 7.

"We've been through this fairly regularly. This is getting to be very frustrating. But I think investors are taking this very well," said Thayer. "A lot of people realized this could lead to a government shut down again. That by itself was not as significant as defaulting on debt…That would be a bigger damaging event to the economy, of course."

McCarthy said the market is pricing in too much risk of default. While Treasuries were fairly steady, yields on T-bills maturing in October shot up as the Senate and House seemed to drift apart Tuesday. The T-bill maturing Oct. 31 was yielding 0.52 percent in the late afternoon, double the 0.25 percent yield of Tuesday morning.

(Read more: Relax! Government won't run out of money Thursday)

"That's where the market thinks there's a risk of default," said McCarthy. "On the one hand, there's a perception we could get a downgrade which last time ended up being good for Treasurys, but that's offset by the perception of a higher than normal risk of default."

Relief rally?

Thayer said stocks could stage a relief rally if there is a deal reached. "It probably won't be a significant rally like we saw after the fiscal cliff was resolved. This time people are more fully invested and are assuming we will get through it," said Thayer. "I don't think there's as much sideline money coming in to the market if we get through this…It's good for the bond market. It doesn't change too much the expectation on tapering. We'll have to wait to see what happens to the economy and what the Fed says."

The Fed's beige book, released at 2 p.m. ET Wednesday, will be closely watched for what it says about the economy, especially since most government data has not been available since the government shut down Oct. 1.

"If you look at consumer sentiment, they've pulled back. If you look at retail sales, they're a little softer. Gasoline demand softened. It looks to us like we're seeing a modest impact on the economy now," said Thayer. "You can't keep this level of uncertainty for a long time. If we get through this, it won't be in the headlines much and people will start focusing on the everyday things. If we get this out of the headlines, the economy will be okay."

Economists have said the government shut down could amount to about 0.5 percent of GDP growth in a two-week period. Thayer said if the situation is resolved soon, stocks should be able to advance though the market could still be rocky.

(Read more: How debt ceiling crisis will avoid total disaster)

Fed speakers Wednesday include Kansas City Fed President Esther George, a hawkish member of the FOMC and a lone dissenter. She speaks at 6:30 p.m. ET. Dallas Fed President Richard Fisher speaks on breaking up the big banks at 6:45 p.m.

Fisher, a non-voting member, said on Tuesday the lack of economic reports makes it too difficult for the Fed to decide on whether to taper back its $85 billion in bond purchases. He also said it is too soon to say the Fed would not taper this year but it will be hard to make the case in October.

The Fed surprised markets when it kept its bond buying program in tact at its September meeting, but it did cite fiscal uncertainty as one reason. Now some Fed watchers say the government shutdown could keep the Fed easing program in place longer than expected.

Earnings season takes a backseat to Washington so far this week, but there a good number of major reports expected Wednesday, including BlackRock, Bank of America, Pepsico, Bank of NY Mellon, Abbott Labs, KeyCrop, PNC Financial and St. Jude Medical ahead of the opening bell. After the market close, American Express, IBM, eBay, Sandisk, SLM, Noble, El Paso Pipeline Partners and Xilinx report.

Intel may also be of interest Wednesday, after its stock traded lower after its post-market earnings report. Intel earnings were better than expected but it issued a revenue forecast for the current quarter below analysts' expectations.

(Read more: Wal-Mart CEO sees government shutdown impact)

The National Association of Home Builders will be issuing its sentiment survey at 10 a.m. ET.

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