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* BoC: C$ dampening economy, a factor in assessing policy
* C$ ends down at 97.17 U.S. cents, near session low
* Bonds rise strongly as risk sentiment fades (Updates to close)
By Ka Yan Ng
TORONTO, June 22 (Reuters) - The Canadian dollar finished lower against the greenback on Tuesday after the Bank of Canada said the currency's drag on the Canadian recovery could be a key issue in future monetary policy.
Bank of Canada Deputy Governor Timothy Lane said the value of the Canadian currency against the U.S. dollar would affect the central bank's decision on interest rates on July 20 and beyond, sending the currency to a session low at C$1.0296 to the U.S. dollar, or 97.13 U.S. cents. [ID:nTOR007606] [ID:nN22144820]
His comments, coupled with earlier data that showed domestic inflation was not a threat, put a brake on near-term rate-hike expectations. [ID:nN22110502]
"It's casting a bit of doubt as to what the bank is going to do at the next meeting," said John Curran, senior vice-president at CanadianForex.
"But I still think if we continue to get decent numbers out of Canada they'll hike rates again."
Markets have priced in a nearly 80 percent probability that the Bank of Canada will raise interest rates at its next policy setting announcement in July -- slightly lower than in the previous session. The bank raised its key rate this month by a quarter-point to 0.5 percent. BOCWATCH
The Canadian dollar finished near its session low at C$1.0291 to the U.S. dollar, or 97.17 U.S. cents, down from Monday's close at C$1.0244 to the U.S. dollar, or 97.62 U.S. cents.
The currency's weakness was exacerbated by the rapidly declining price of oil and equity markets, which fell in part because of a surprise drop in U.S. existing home sales in May as well as a ratings downgrade of French bank BNP Paribas. [ID:nN22382886] [MKTS/GLOB]
Canadian government bond prices shot higher on a rethink of the path of interest rates, while riskier assets such as equities were also falling out of favor.
A slower pace of gasoline price increases helped the annual inflation rate ease to 1.4 percent in May from 1.8 percent in April, Statistics Canada said.
The core rate of inflation, which excludes volatile items like gasoline and is the Bank of Canada's most trusted gauge of underlying price trends, came in at 1.8 percent versus 1.9 percent in the previous month. This was just above the 1.7 percent forecast for May.
"There probably is a little bit of inflation calm that is contributing to this, but the real story is one in which global bonds are rallying quite aggressively," said Eric Lascelles, chief Canada macro strategist at TD Securities.
"You could make the case that the risk-off trade is starting to dominate again and that's helping this bond rally quite nicely."
Domestic bonds tracked U.S. Treasuries, which rose in price as weak housing data and shaky stocks underscored the fragile state of the economic recovery. [US/]
The two-year government bond CA2YT=RR jumped 10 Canadian cents to yield 1.689 percent, while the 10-year bond CA10YT=RR rose 63 Canadian cents to yield 3.253 percent.
Canadian bonds were mixed against U.S. Treasury issues, with short-term bonds outperforming and long-dated issues underperforming. The Canadian 10-year bond yield was 9.4 basis points above its U.S. counterpart, compared with 8 basis points on Monday.