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At its last meeting the Federal Reserve extended operation twist through the end of the year whereby it sells its shorter term Treasuries and purchases longer term Treasuries to keep the yield on the Ten Year Treasury as low as possible. The primary objective is to lower mortgage rates to encourage home buying and mortgage refinancing. At the meeting the Fed lowered its anticipated inflation rate to 1.75% and its 2012 anticipated unemployment rate to 8.2% for 2012. The Fed didn't launch QE3 primarily because of the upcoming November 2012 Presidential Elections and an interest in seeing more data. If the Federal Reserve launches QE3 look for it to go big and again target direct purchases of Agency Mortgages such as those issued by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). The markers the Fed is looking at are first and foremost inflation and then unemployment and they are prepared to act aggressively if they are once again forced to lower their forecast of economic activity.

The most significant economic report since the last Federal Reserve meeting on June 20 has been the Institute for Supply Management Manufacturing Report. The June number came in below the consensus at 49.7. Anything below 50 is considered contracting and recessionary. The most shocking part of the report was the prices paid for raw goods component. The number dropped from 47.5 to 37, which is deflationary. While the Fed is concerned about near zero growth, it is especially concerned about a further slowdown in inflation, no less deflation. New orders in the report fell from 60.1 to 47.8 representing a dramatic slowdown in future growth and employment. If more data like this continue to emerge there will be pressure on the Federal Reserve to move before the election. Housing and construction data that has come out in the last couple of weeks has been encouraging. But housing is a lagging indicator because most mortgages take 6 weeks or longer to close.

If the Fed launches QE3 it will be directly targeting mortgages. The biggest direct beneficiaries will be banks with large mortgage operations. The five largest mortgage lenders in 2012 are Wells Fargo (NYSE:WFC), JPMorganChase (NYSE:JPM), Bank of America (NYSE:BAC), Citi (NYSE:C), and U.S. Bankcorp (NYSE:USB). The mortgage divisions of these banks would perform very strongly if QE3 is accompanied by easing lending standards from Fannie and Freddie. In 2007 the average credit score receiving approval from Fannie was 716, now it is close to a high of 762. Simply lowering the average score to 740 would provide a major boost to mortgage lenders.

Because of the uncertainty of the elections in Greece and the outcome of measures to ease pressure on the bonds of Spain and Italy the Federal Reserve will want to wait for July data to see if the economy is experiencing a temporary lull or the beginning of a downward trend. The Fed will pay close attention to any further pricing erosion in commodities like oil and copper. They will also pay attention to the 10 year yield of Spanish and Italian bonds to see if they go back over the 7% range in yield. If the dramatic drop in new orders and pricing in the ISM Manufacturing data is not reversed quickly it will portend a contractionary trend and not a temporary lull and the Fed can be expected to launch QE3.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Slowing Economy To Spur Federal Reserve To Launch QE3