* C$ closes at 96.22 U.S. cents
* Currency hits highest since Aug. 20
* U.S. jobs fall less than expected
* Bank of Canada rate hike expectations rise
* Bonds prices fall after better data (Updates to close, adds details, quotes)
By Claire Sibonney
TORONTO, Sept 3 (Reuters) - The Canadian dollar rallied to a two-week high against the greenback on Friday, climbing more than a penny, after an upside surprise in U.S. job data increased expectations Canadian interest rates will rise next week.
U.S. employment fell for a third straight month in August, but the drop was only half the anticipated loss, and private hiring growth -- considered a better gauge of labor market health -- beat consensus. [ID:nN02227856]
U.S. service sector activity data came in weaker than forecast, but at a level that still qualifies as expansion rather than contraction. [ID:nN03111828]
The data from Canada's largest trading partner drove the Canadian dollar CAD=D4 as high as C$1.0384 to the U.S. dollar, or 96.30 U.S. cents, its strongest level since Aug. 20.
"The market really took it from a bullish point of view so we have seen stocks rally and government bonds sell off and we've seen generally risk currencies do fairly well," said Tom Nakamura, fixed-income portfolio manager at AGF Investments.
In a note to clients, Doug Porter, deputy chief economist at BMO Capital Markets, said it wasn't every day that the market greets a "not-horrendous" jobs report with open arms.
"It's nothing to write home from summer camp about, but the gains are consistent with an economy that is still grinding forward," the note said.
The Canadian dollar ended the North American session at C$1.0393 to the U.S. dollar, or 96.22 U.S. cents, up sharply from Thursday's close at C$1.0535 to the U.S. dollar, or 94.92 U.S. cents. It gained 1.3 percent for the week.
RATE EXPECTATIONS JUMP
Investors have feared sustained weakness in the United States could spill over to Canada's economy, which has dragged on the currency in recent weeks.
"When it looked like our major trading partner was going into the dumps, CAD underperformed and now that it looks like they maybe aren't going into the dumps as quickly as anticipated, CAD is storming back," said David Watt, senior currency strategist at RBC Capital Markets.
The Bank of Canada decides on interest rates on Sept. 8 in one of the closer calls in some time. [CA/POLL] [ID:nN01259189]
Financial markets raised the probability of a hike to nearly 63 percent from around 52 percent before the jobs data, according to a Reuters calculation based on yields on overnight index swaps. BOCWATCH
That move allowed the currency to catch up after underperforming earlier in the week, added AGF's Nakamura.
Higher interest rates and the expectation of higher rates, tend to attract capital and stoke demand for a country's currency.
BOND PRICES SLUMP
With the U.S. labor market data alleviating some fears the world's biggest economy may succumb to a double-dip recession, U.S. Treasury prices drifted lower, pulling down Canadian government debt prices. [US/].
Bond prices typically fall when interest rates go up as their low-yielding fixed payments seems less lucrative compared to rising yields on other short-term investments.
Canada's rate-sensitive two-year bond CA2YT=RR shed 18 Canadian cents to yield 1.376 percent and the 10-year issue CA10YT=RR sank 67 Canadian cents to yield 2.946 percent.
"The market is trying to assess how likely is a double-dip scenario, how likely is a deflationary scenario and in relation to the U.S., how likely is it that we're going to see more quantitative easing," said Nakamura.
"For today, it is a lower probability of those three things." (Editing by Jeffrey Hodgson)