TORONTO (Reuters) - Canada's dollar logged its biggest one-day gain this year against the U.S. currency on Tuesday after the Bank of Canada surprised traders by suggesting that it was closer to raising interest rates as economic conditions improve at home and abroad.
The Canadian dollar was a leading gainer among major currencies, jumping nearly 1 percent after the central bank kept rates unchanged, as expected, but signaled that it was starting to think more seriously about tightening monetary policy.
"The prospect of higher interest rates has caused the Canadian dollar to strengthen," said Mark Chandler, head of Canadian fixed income and currency strategy at Royal Bank of Canada.
Higher interest rates or expectations of higher rates tend to help currencies strengthen by attracting international capital flows.
The Canadian currency firmed to a near one-month high at C$0.9865 versus the U.S. dollar, or $1.0137, after the release of the bank statement. It was at C$0.9958 immediately before the release.
Chandler also pointed to the broader increase in risk appetite, led by solid demand at a Spanish bill auction and upbeat German investor sentiment, which boosted commodity prices and resource-linked currencies. <MKTS/GLOB> <O/R> <MET/L>
The Canadian dollar finished at C$0.9902 against the U.S. dollar, or $1.0099, up nearly a cent from Monday's North American close at C$0.9997 versus the greenback, or $1.0003. It was the largest single-day jump since November.
The Bank of Canada has frozen rates at 1 percent since September 2010 after it became the first in the G7 to raise borrowing costs from lows hit during the financial crisis.
Analysts said the bank's tone in Tuesday's statement was more hawkish than expected and seemed to signal rate hikes sooner than previously predicted.
Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that after the rate statement traders priced in higher odds of a rate hike later this year.
"The market is certainly playing (a rate increase) towards the end of this year," said Mazen Issa, macro strategist at TD Securities. "From where we were six months ago, this is a drastic improvement."
A Reuters survey of the country's primary dealers, conducted immediately following the Bank of Canada announcement, showed the median forecast for the timing of the next rate increase being pushed up to the first quarter of 2013. <CA/POLL>
Issa said that after Tuesday's big jump, the Canadian dollar was not likely to strengthen much further and would remain around C$0.99 against the U.S. currency, or $1.01, close to the high end of where it has traded since January.
Canadian government bond prices fell after the bank's more positive economic outlook.
The yield on the two-year bond, which is especially sensitive to Bank of Canada interest rate moves, rose to 1.333 percent from 1.26 percent just before the release.
The benchmark 10-year bond fell 49 Canadian cents to yield 2.070 percent.
Canadian government bond prices underperformed U.S. Treasuries after the news, especially at the short end of the yield curve.
With the rate announcement done, the market will focus on the Bank of Canada's Monetary Policy Report on Wednesday, which is followed by a press conference by Governor Mark Carney.
"The way it stands right now the market has a 50-50 chance that (Carney) would move as soon as September. He may not be comfortable with the market interpreting a move anytime sooner than that," said Chandler.
Editing by Jeffrey Hodgson