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* C$ falls to C$0.9860 vs US$, or $1.0142 * Canadian economy unexpectedly shrinks in Feb * Bond prices rally across curve By Claire Sibonney TORONTO, April 30 (Reuters) - Canada's dollar weakened to a session low against its U.S. counterpart on Monday as bond yields retreated after data showed the domestic economy unexpectedly shrank in February. Canada's economy contracted by 0.2 percent a couple months ago, hit by temporary closures in mining and other goods-producing industries. Market analysts had on average predicted the economy would grow by 0.2 percent from January. After the release, Canada's dollar skidded to C$0.9865 versus the greenback, or $1.0137, from around C$0.9829, or $1.0174, heading into the data. "Obviously the numbers in terms of February were very disappointing ... so we've seen the (implied interest rate) strip rallying accordingly," said Jeremy Stretch, head of foreign exchange strategy at CIBC World Markets in London. "Consequently we've seen dollar/CAD grinding higher, which all makes perfect sense in the current environment or at least in the immediate backwash of the data point." Canada's currency has been supported in the last couple weeks by ramped-up expectations of interest rate hikes by the Bank of Canada, which surprised investors with a more positive domestic economic outlook and explicit warning that it may have to start raising rates again. The more-hawkish-than-expected central bank had promoted a significant widening in two-year bond spreads between Canada and the United States. Following the data on Monday however, bond prices jumped and yields dropped, while the pricing of overnight index swaps also showed traders had cut back prospects of rate increases for the remainder of the year. At 9:18 a.m. (1318 GMT), the Canadian dollar stood at C$0.9860 versus the U.S. dollar, or $1.0142, down from Friday's finish at C$0.9810 versus the U.S. dollar, or $1.0194, after the Canadian dollar advanced to a seven-month high. Stretch said the Canadian dollar could soften further to around C$0.9870-80 in the short term, noting weakness against the euro as well, though risk factors in the euro zone would far outweigh any concerns about a monthly GDP number in Canada. Canadian government bonds outperformed their U.S. counterparts across the curve following the negative surprise in Canada's February GDP. The rate-sensitive two-year bond rallied 13 Canadian cents to yield 1.366 percent, while the benchmark 10-year bond climbed 32 Canadian cents to yield 2.050 percent.