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TORONTO (Reuters) - The Canadian dollar fell against its U.S. counterpart on Tuesday after the Bank of Canada said the economy would take longer than it had forecast to reach full production and dropped any mention of the need to raise interest rates.
The Canadian dollar abandoned its early-session climb above parity with the U.S. dollar after the surprisingly soft language from the central bank in its scheduled policy announcement, sinking more than a cent as European optimism also faded ahead of a key euro-zone summit Wednesday.
The Bank of Canada downgraded its forecast for the closing of Canada's output gap to the end of 2013 from the middle of 2012. Economists said this was a significant nod to global growth concerns and likely means the chances of an interest rate increase any time soon have faded.
"One (thing that stands out) is the change in their outlook. That is pretty powerful with respect to (moving) the closing of the output gap from the middle of 2012 to the end of 2013, which suggests they could be on hold for a very, very long time," said Michael Gregory, senior economist at BMO Capital Markets.
The bank left official interest rates unchanged at an ultra-low 1 percent, as expected, but the shift to a more dovish stance on future rate moves makes the Canadian currency less attractive to investors looking for higher returns.
Overnight index swaps, which are based on expectations for the key central bank policy rate, showed traders increased bets on a rate cut in the coming year after the Bank of Canada announcement.
At 9:49 a.m. (1349 GMT), the Canadian dollar stood at C$1.0136 to the U.S. dollar, or 98.66 U.S. cents, near the session low and far below the session high above parity at C$0.9990 to the U.S. dollar, or $1.0010, hit in early morning trade.
The currency had strengthened through parity for the first time since September 21 as investors bet that European leaders would find a solution to the debt crisis that would help restore global economic growth, despite the huge obstacles that still face the euro zone.
The leaders are to meet on Wednesday with tentative plans in place for Greece's debt to be reduced, European banks to be recapitalized and the euro zone's EFSF rescue fund to be increased to provide partial insurance for sovereign bonds.
But the agreements remain tentative and under discussion, causing some nerves on financial markets.
Canadian government bond prices climbed after the dovish central bank statement and mostly outperformed U.S. Treasuries.
The two-year bond soared 21 Canadian cents, bringing the yield back inside the official overnight rate to 0.997 percent. The yield was at 1.11 percent just before the announcement.
The 10-year bond climbed 47 Canadian cents to yield 2.315 percent.
Editing by Peter Galloway and Jeffrey Hodgson