A constructive day but the short-term key remains CPI inflation on Wednesday

The Standard & Poor’s 500 and the Dow Jones Industrial Average both finished in the green today, up 1.39% and 1.70%, respectively, after having held off a bout of selling around 3:46 p.m. New York time.

Volatility also made progress on returning to normal. The CBOE S&P 500 Volatility Index (VIX) fell 11.87% to 25.61. That’s still above the long-term average for the “fear index” near 19. But the market for hedging risk made important progress toward returning its normal curve where it costs more to insure against longer-term risk in the options market than against near-term risk.

During this sell off the relationship inverted–investors and traders were so worried about what the market might do tomorrow that they were willing to pay more to buy options that insured against short-term risk than against risk a month or more away. Today, however, an option to buy the VIX at $26 on February 14–a bet that will only pay off if the Vix climbs to 26 or higher by Wednesday–was selling for $2.05.

That’s the same price as a call option at 26 good until March 21 and a call option at that level for April 18. We’ll know we’re back to normal when the fact that it’s harder to see two months into the future than it is to see two days into the future is reflected again in a higher price for the longer-dated option. But even parity is a big improvement.

All this improvement could come undone if on Wednesday the CPI inflation numbers for January indicate that inflation has moved higher than expected. That would revive worries that the Federal Reserve will be more aggressive than expected on raising interest rates. As I handicapped these numbers in my weekend Saturday Night Quarterback post on my subscription JubakAM.com site, as of Friday economists surveyed by Briefing.com were projecting that the headline (sometimes called the “all-items”) CPI climbed 0.4% in January. That would be a huge increase from the 0.1% increase in December. (The December number was a result of a big drop in energy costs.)

The December increase left the annual headline CPI inflation running at a 2.1% annual rate, slightly above the Fed’s inflation goal of 2%.  In December the core CPI, which excludes more volatile food and energy prices and is closer to the inflation number that the Fed watches,  was up 0.3%, higher than the 0.2% economists had expected. For January economists are projecting a smaller 0.2% increase in core CPI. Anything at that level or lower would be reassuring to the financial markets. In December the core CPI was running at a 1.8% annual rate.

I think the uncertainty about Wednesday’s data on inflation will make it hard for the market tomorrow to show much progress on healing the damage done during this correction.

But a benign inflation number on Wednesday would help keep the short-term progress going.