TORONTO (Reuters) - The Canadian dollar stumbled against its U.S. counterpart and domestic bond yields retreated on Monday after data showed the economy unexpectedly shrank in February, cooling expectations that the Bank of Canada will soon resume raising interest rates.
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.
"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.
"The market was expecting maybe a little bit of a disappointment on the GDP and we got a lot of disappointment."
He added he was a little surprised by the market's strong reaction, but said month end flows could be exaggerating the move.
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.
The Canadian dollar finished 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.
The Canadian dollar, which hit seven-month high on Friday, was still up 1 percent for the month, its best monthly gain since February.
Canada's currency has been supported in the last two weeks by ramped-up expectations of interest rate hikes by the Bank of Canada. The central bank surprised investors with a more positive domestic economic outlook and an explicit warning that it may have to start raising rates again.
That message was reiterated on Monday in a speech in Ottawa by Bank of Canada Deputy Governor Timothy Lane.
The more-hawkish-than-expected central bank had caused a significant widening in two-year bond spreads between Canada and the United States. The spread hit a 2012 high above 115 basis points last week. It has since dipped to around 108 basis points.
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."
Carney has spoken about the country's economic outlook on several occasions this month.
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 17 Canadian cents to yield 1.343 percent, while the benchmark 10-year bond climbed 35 Canadian cents to yield 2.047 percent.
Additional reporting by Claire Sibonney; Editing by Jeffrey Hodgson