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* C$ falls to C$0.9879 vs US$, or $1.0122 * Canadian economy unexpectedly shrinks in Feb * Bond prices move higher across curve By Jennifer Kwan TORONTO, April 30 (Reuters) - Canada's dollar sagged against its U.S. counterpart and domestic bond yields retreated on Monday after Canadian GDP unexpectedly shrank in February and Spain stoked euro zone worries. Canada's gross domestic product contracted by 0.2 percent in February from January, data showed, surprising analysts who had expected a 0.2 percent increase. The report disappointed markets and cooled talk that the Bank of Canada could start raising interest rates in the near future. The Canadian currency also tracked a fall in global stock markets on data showing Spain slipped into recession and the U.S. economy appeared to be slowing. "Blood and guts all over the street today," said Steve Butler, managing director of foreign exchange trading at Scotiabank, of the move in the Canadian currency. "I think the market was expecting maybe a little bit of a disappointment on the GDP and we got a lot of disappointment in the GDP number," he said. He added he was a little surprised about the market's strong reaction, but said month end flows could be exaggerating the move. At around 12:55 a.m. (1655 GMT), the Canadian dollar was at C$0.9879 versus the U.S. dollar, or $1.0122, down from Friday's finish at C$0.9810 versus the U.S. dollar, or $1.0194, following the Canadian dollar's advanced to a seven-month high. Canada's currency has been supported in the last couple weeks by ramped-up expectations of interest rate hikes by the Bank of Canada. It surprised investors with a more positive domestic economic outlook and an 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. "The market, in my mind, got carried away from comments by (Bank of Canada Governor) Carney," said Butler, "all of a sudden pricing in rate cuts this year, more than one potentially, was much, much too aggressive. I think the market is feeling a little bit of that today." Jeremy Stretch, head of foreign exchange strategy at CIBC World Markets in London, 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 rose 16 Canadian cents to yield 1.348 percent, while the benchmark 10-year bond added 26 Canadian cents to yield 2.057 percent.