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TORONTO (Reuters) - The Canadian dollar rallied against the U.S. dollar on Tuesday after a domestic inflation report beat estimates, but gave up most of those gains ahead of an impending U.S. Federal Reserve interest rate decision.
Domestic bond prices were pinned lower across the curve as U.S. equity futures pointed to a higher open, lessening the demand for more secure assets like government debt.
At 8:30 a.m., the Canadian currency was at US$1.0048, valuing a U.S. dollar at 99.52 Canadian cents, up from US$1.0007, valuing a U.S. dollar at 99.93 Canadian cents, at Monday's close.
Domestic inflation data released earlier helped boost the currency to US$1.0109, valuing a U.S. dollar at 98.92 Canadian cents, but much of those gains evaporated within 15 minutes as investors turned their focus to earnings from U.S. investment banks and a rate decision from the Fed.
The data showed Canada's annual inflation rate eased in February, but core inflation, which excludes volatile items like gasoline and guides monetary policy, rose to 1.5 percent from 1.4 percent in January.
"We just have to wait and see what the Fed does today, but certainly the market is not reacting as you'd expect from these (inflation) numbers," said Steve Butler, director of foreign exchange trading at Scotia Capital.
"Everybody has got in the back of their minds the (Fed) decision later this afternoon, and there's so many different scenarios that we can think about so everybody is just going to have to wait and see."
The market is pricing in a cut of at least 100 basis points to the Fed's benchmark lending rate of 3 percent, and some investors expect an even bigger 125-basis-point cut, as the Fed attempts to rally a flagging U.S. economy.
Either way, the Canada-U.S. rate gap will widen in favor of the Canadian currency, with the Bank of Canada's key overnight rate at 3.50 percent since it last cut rates on March 4.
Canadian bond prices remained locked in at the lower levels hit ahead of the domestic inflation report and risk further declines as equity markets look poised to open higher.
It marks a sharp turnaround from Monday's session when bond prices rallied on a safe-haven bid as credit concerns from the United States rattled the domestic stock market and sent investors scurrying for more secure assets.
"Basically the fact that equity futures in the U.S. are up more than a full percentage point so yields in the U.S. have backed up and Canada, if anything, has lagged a little bit here in the backup in yields," said Mark Chandler, fixed income strategist at RBC Capital Markets.
"But obviously very tentative ... as the FOMC later today is going to drive things."
The overnight Canadian Libor rate was 3.7166 percent, up from 3.6750 percent on Monday.
The two-year bond was down 10 Canadian cents at C$103.12 to yield 2.364 percent. The 10-year bond dropped 27 Canadian cents to C$104.41 to yield 3.435 percent.
The yield spread between the two- and 10-year bond was 107.4 basis points, up from 109.6 points at the previous close.
The 30-year bond declined 54 Canadian cents to C$117.25 to yield 3.993 percent. In the United States, the 30-year treasury yielded 4.308 percent.
The three-month when-issued T-bill yielded 2.04 percent, down from 2.10 percent at the previous close.
Editing by Bernadette Baum