The ECB statement and ECB President Trichet's press conference disappointed the markets by not embarking on any new easing facilities. They will remain committed to offering unlimited three-month loans to banks but did not go as far as increasing the maturity of any loans to six months or one year - something the markets had perhaps anticipated. Without that extra commitment the euro fell.

The ECB no longer sees upside risks to inflation, instead seeing inflation risks balance.

From the Introductory Statement: The Governing Council views the risks to the medium-term outlook for price developments as being broadly balanced. On the upside, the main risks relate to the possibility of higher than assumed increases in oil and non-oil commodity prices as well as increases in indirect taxes and administered prices, owing to the need for fiscal consolidation in the coming years. The main downside risks relate to the impact of weaker than expected growth in the euro area and globally.

The ECB will have to undertake a review of all incoming data to see whether inflation expectations remain firmly anchored, so we may have to wait till the October meeting to get a better reading on the path forward for medium-term inflation.

A very thorough analysis of all incoming data and developments over the period ahead is warranted.

At the same time the ECB sees the growth outlook no longer balanced, but instead the downside risks increasing.

Looking ahead, a number of developments seem to be dampening the underlying momentum in the euro area, including a moderation in the pace of global growth, related declines in equity prices and in business confidence, and unfavourable effects resulting from ongoing tensions in a number of euro area sovereign debt markets. As a consequence, real GDP growth is expected to increase very moderately in the second half of this year. At the same time, we continue to expect euro area economic activity to benefit from ongoing growth in the global economy as well as from the accommodative monetary policy stance and the various measures taken to support the functioning of the financial sector...

Looking ahead, we expect the euro area economy to grow moderately, subject to particularly high uncertainty and intensified downside risks. At the same time, short-term interest rates are low. While our monetary policy stance remains accommodative, some financing conditions have tightened.

Therefore overall the ECB message is a much more dovish one than in its previous statements, and the fact that we have no easing or no new lending facilities can hamper risk in the European continent, while the fact that the ECB has shelved its rate hike campaign will hurt the euro from an interest rate yield expectation standpoint.

Market Reaction: The EUR/USD responded by falling from its level around 1.4065 prior to the release down to below 1.40 testing a new low for this week at 1.3940. It did manage to bounce back, showing that the market was not ready to push the pair below that important 1.40 area. The euro was also pressured heavily against the pound with the EUR/GBP falling from a high of 0.8040 all the way down to 0.8725 - wiping away the gains for the euro we had in the previous two sessions. The euro was also weaker against other rivals including the Japanese yen and the Australian dollar.

Market Impact: The implication going forward of a more dovish ECB, with interest-rate hikes off the table for the foreseeable future, means that the euro will suffer against those currencies which are still set see their central banks raising rates - like the RBA and BOC - though those central banks will likely wait till 2012 before hiking rates.

More importantly, if the euro zone economy continues to deteriorate we may see the ECB move to an easing stance, with the possibility of reducing the interest-rate increases they had done this year bringing rates from 1% up to 1.5%. Such a move would certainly undermine the euros strength against other higher yielders, but also could undermine it against US dollar as well as we unwind some of the gains in the EUR/USD from earlier in the year as a result of pricing in these interest rate hikes.

Nick Nasad
Chief Market Analyst