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Stocks close sharply lower as Washington impasse weighs

Stocks closed sharply lower in volatile trading Tuesday, with the Dow and S&P 500 snapping their four-day rally, as the impasse over the government shutdown and debt ceiling continued to weigh on the markets.

Major averages took a leg lower after Senator Dick Durbin said Senate fiscal negotiations have been suspended until House Republicans work out plan to proceed on debt limit and government funding.

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

The Dow Jones Industrial Average closed 133 points down, dragged by McDonald's and IBM. The S&P 500 and the Nasdaq also dropped.

The CBOE Volatility Index (VIX), widely considered the best gauge of fear in the market, jumped above 17.

All key S&P sectors were in the red, dragged by consumer discretionary and financials. But all eyes were on Washington and efforts to resolve the budget impasse, end the government shutdown and agree on increasing the debt ceiling.

"The best case solution to the current government shutdown would have been for the two parties to reach an agreement on important issues before hitting the debt ceiling deadline. Unfortunately, that appears very unlikely at this late date," according to Gary Thayer, chief macro strategist at Wells Fargo Advisors.

"At the other end of the spectrum, the worst-case scenario of a debt or spending default is still possible but is probably not as big a threat as many investors thought a week ago when the two parties appeared to be at an impasse," he said. "We continue to believe that the most-likely scenario is for lawmakers to agree to a modest increase in the debt ceiling that avoids default and gives lawmakers time to negotiate over political differences during the next few months."

House Speaker John Boehner said that the GOP was still involved with talks with House Democrats, and despite hopes for a deal today none was yet forthcoming.

Stocks fluctuated in a narrow range for most of the trading session amid headlines from Washington. Earlier, House GOP leaders unveiled a plan that would suspend a new tax on medical devices for two years and take away the federal government's contributions to lawmakers' and top administration officials in addition to funding the government through Jan. 15 and giving Treasury the ability to borrow normally through Feb. 7. 

The back-and-forth came as the partial shutdown entered its third week and less than two days before the Treasury Department says it will be unable to borrow and will rely on a this cash cushion to pay the country's bills.

On the economic front, the pace of growth in New York state's manufacturing sector slipped in October to its slowest since May, according to the New York Fed's "Empire State" general business conditions index.

Meanwhile, Dallas Federal Reserve President Richard Fisher said he sees no reduction in the central bank's stimulus package of bond-buying this month, due to the fiscal standoff in Washington.

"This is just too tender a moment,'' said Fisher.

"Markets will be closely watching the momentum in the mortgage businesses, particularly after the slowdown in refinancing volumes and cost cuts reported in the JPM (JPMorgan Chase) and Wells Fargo results late last week," said Deutsche Bank analysts Jim Reid and Anthony Ip in a research note.

(Read more:Companies worry about 'stepping on a bomb')