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TORONTO (Reuters) - The Canadian dollar rallied into the end of 2011, albeit in holiday-thinned volume, heralding what many analysts believe will be a better year for the economic growth-sensitive currency in 2012.
Canada was a mediocre performer among G10 currencies in 2011, down 2.2 percent after a roller-coaster second half of the year during which trade was driven by headline risk out of Europe. In 2010, the Canadian dollar had a 5.7 percent gain against the greenback.
The lackluster performance by the Canadian dollar in 2011 - as well as a slumping Canadian equity market - reflected slowing global economic growth, which spurred spikes in risk aversion and volatility in commodity prices.
"Once we get out of the specific near-term, high-risk environment, the outlook is fairly good for the Canadian dollar in the sense that it's increasingly difficult to turn towards Europe as an investment," said Camilla Sutton, chief currency strategist at Scotia Capital. "I think portfolio managers globally will be looking for alternatives, and Canada fares fairly well on that in the sense that we are a triple-A rated country with a bond market."
A stronger-than-expected U.S. economic outlook and U.S. oil prices holding in around $100 should also support Canada, especially with market volatility dropping off from autumn highs.
"The biggest risk is a sudden escalation in Europe, or the other big risk is just if we see a far bigger slowdown than we expect from China, which would be negative for the Canadian dollar," Sutton cautioned.
On Friday, Canada's commodity-linked currency was seen getting a lift from positive year-end flows from asset managers as well as from a rebound in the euro after Spain announced a slew of measures to control spending. <FRX/>
While analysts said the euro would continue to be under pressure next year as the region's debt crisis continues to flare, the Canadian dollar is expected to do better, although the ride will be bumpy. Forecasts have it sharply weaker by mid-year, but strengthening back towards U.S. dollar parity by the end of 2012.
The Canadian dollar closed Friday's North American session at C$1.0170 versus the greenback, or 98.33 U.S. cents, up from Thursday's finish of C$1.0208, or 97.96 U.S. cents.
Volume this week has been very light, with many traders off for the Christmas and New Year's holidays, causing market players to be skeptical of the importance of any sharp moves.
Investors will look for confirmation of recent activity next week when markets return to more normal trading levels ahead of closely watched North American employment data next Friday.
The currency was up 0.4 percent for the week, 0.3 percent for the month and 3.1 percent for the quarter. The Canadian dollar is down 7.5 percent from its 2011 high above parity in July.
"I think the Canadian dollar had also gotten a bit overdone at its peak levels. Even in a world of $100 oil, it was going to be hard for Canada to sustain such a strong exchange rate and despite high commodity prices we were still running a trade deficit," said Avery Shenfeld, chief economist at CIBC World Markets.
The story of a stronger Canadian dollar in the second half of 2012 will depend on European policymakers taking the steps necessary to get past the market's worst fears, Shenfeld said.
"If we don't have a true blowup in Europe, then at a minimum the rate cuts that are priced in for the Bank of Canada won't happen, which would be a positive for the Canadian dollar."
Still, CIBC is not calling for a Bank of Canada interest rate hike until 2014, a longer wait than other primary dealers have forecast.
Canadian government bond prices were little changed in a shortened session for the last trading day of the year, but mostly underperformed the U.S. Treasury market, which was the best performing major asset class of 2011. <US/>
Analysts said the year ahead could see U.S. Treasuries continue to beat Canadian bonds, particularly at the long end of the curve, as opposed to the interest-rate sensitive short end that is expected to be stagnant with neither the U.S. nor the Canadian central banks tightening monetary policy.
"If we don't have the full-blown euro zone crisis, then we will see bonds lose a bit of their safe-haven appeal. So we would expect 10-year rates to be drifting higher over the course of 2012," Shenfeld said.
"We have a little bit of a widening in the spread between Canada and the U.S. so Canada underperforming in 2012, largely because of the Fed's support for the long end through its term extension program," he said. "If we look beyond 2012 we would expect the Canadian bond market to once again start to outperform the U.S."
The two-year bond ended flat on Friday to yield 0.954 percent, down from 1.678 at the end of 2010. The 10-year bond gained 3 Canadian cents on the day to yield 1.944 percent, down from 3.117 last year. The 30-year bond ended up 12 Canadian cents to yield 2.492 percent, down from 3.523.
Canadian financial markets are closed on Monday.
Reporting by Claire Sibonney; Editing by Peter Galloway