* Investors hoping compromise wins out over confrontation
* Hopes for a solution on signs of a spirit of compromise
* Risk of another battle royal, default can't be ruled out
By Steven C. Johnson
NEW YORK, Jan 13 (Reuters) - The U.S. government is expected to bump up against its legal borrowing limit by March, and it would be hard to fault investors for feeling edgy.
The last fight over the debt ceiling led to one of the most volatile weeks in stock market history, cost the United States its top credit rating and pushed the government to the brink of default.
But this time around, markets are remarkably calm, with the benchmark S&P 500 barely budging on Friday after notching a five-year closing high on Thursday. Some investors seem to be betting that Congress learned its lesson from the bruising debt ceiling fight of 2011 and will choose compromise over market meltdown.
Lawmakers remain far apart in their views. Republicans want the White House to agree to deep spending cuts in exchange for raising the $16.4 trillion borrowing limit. However, some conservative voices are warning against playing hardball with the debt ceiling.
"We played this game of chicken before and we all know how that played out and we don't want to repeat that. The market knows this. Investors know it's not going to be like 2011," said Jack De Gan, the chief investment officer at Harbor Advisory in Portsmouth, New Hampshire. "I think the negotiation will go by with less volatility."
Meanwhile, the CBOE Volatility index, Wall Street's preferred anxiety gauge that is known as the VIX, ended Friday just a few hundredths of a point from its lowest closing level since 2007.
Of course, market mood can change in a heartbeat, and there's still plenty of time for anxiety to rise.
Markets are still counting their blessings after Congress struck a last-minute deal on New Year's Day to avoid some $600 billion of automatic tax hikes and spending cuts -- measures that many had feared would drag the economy into recession.
But the deal to avert the "fiscal cliff," which included higher taxes for the wealthiest Americans, delayed some important decisions on spending. That left Republicans with the chance to use the debt ceiling as leverage to get President Barack Obama to make cuts in Social Security, Medicare and other programs.
However, signs that some Republicans may not have the stomach for another fight have not escaped the notice of investors and traders.
In the equity markets, futures contracts on the VIX suggest expectations for rising volatility in coming months, but not at a rate that is considered alarming. Randy Frederick, managing director of active trading and derivatives at Charles Schwab, said investors have shown some interest in February VIX call options at 17, which is a bet on a rise in volatility around the time the debt ceiling debate is expected to heat up.
"I haven't seen a whole lot of action," he said. "I think the market will stay in a trading range until we get closer to the deal. We still have three to four weeks until we get too uptight or worried about the situation."
Prices of U.S. Treasuries have also been fairly steady as investors weigh an improving economy against impending battles over the federal debt ceiling.
Some senior Republican figures have expressed concern about their party being blamed for a shut down of the government or a debt default.
Former Republican House Speaker Newt Gingrich, whose decision in the 1990s to shut down the government rather than raise the debt ceiling backfired politically, told MSNBC this week that a repeat performance would be a "dead loser" for the party.
In Thursday's Wall Street Journal, Republican strategist Karl Rove said the party may have to accept a debt ceiling increase that doesn't come with cuts to Social Security and Medicare programs.
"Having been defeated in the last election, the Republicans might not want to lose their last vestige of power, which is the House of Representatives, in the next one, so there may be some kind of incentive on both sides to get something done," said Millan Mulraine, senior bond strategist at TD Securities.
"Of course, the market is very mindful that we have a very polarized environment in Washington that has manifested itself in almost every aspect of policymaking," he added. "But I still think markets expect a deal."
That's not to say investors shouldn't prepare for the worst.
"These days, it seems like it's dangerous to rule out anything," said Gregory Whiteley, government bond portfolio manager at DoubleLine Capital LP in Los Angeles, which oversees more than $50 billion. "We could see ourselves in a situation where neither side is willing to budge."
Options indicators suggest equity investors are starting to price in the uncertainty - but they're still too sanguine about it, strategists at Credit Suisse said in a Jan. 4 research note. Expectations for volatility two months into the future started to rise just after the new year, compared with the forecast for one-month volatility.
However, the demand for bearish put options versus bullish call options is not particularly high, which "suggests investors may be too bullish on the outcome of the negotiation," they wrote.
In that case, stocks would likely suffer while investors may well look to take cover in Treasury debt, even though that might seem counter-intuitive given the threat of a default or a negative credit rating move. Whiteley and Mulraine both said that scenario would probably remain the case even if Moody's or Fitch decided to follow the 2011 downgrade by Standard & Poor's of the U.S. rating with a downgrade of their own.
U.S. Treasuries maintained strength even after the 2011 debt downgrade by S&P, still seen as a bastion of safety in a world rocked by myriad uncertainties.
Frederick of Charles Schwab said markets probably can handle another bruising battle that goes down to the wire, provided a deal is eventually reached.
He said the combination of the U.S. downgrade and worries that the euro zone could fall apart in 2011 meant there was a double-dose of pain at that time.
"We could be in for a tough battle, but I don't think we will see the meltdown in the market similar to what we saw in 2011," he said.
But at least one high-profile investor said it is too soon to breathe a sigh of relief.
Dan Fuss, vice chairman of Loomis, Sayles & Company with $182 billion under management, said the partisan divide in Washington and politicians' contempt for compromise may one day force investors to reconsider the appeal of U.S. assets.
"My principal concern is the international clients we deal with," he said. "They are really worried about the U.S. government. They look to the U.S. as one of the world's two major powers and it's important to them that we have our act together. So this does worry me a lot."