By John McCrank
TORONTO, March 3 (Reuters) - A report showing that the Canadian economy cooled in the fourth quarter took the wind out of the sails of the Canadian dollar on Monday as investors bet the Bank of Canada will make a deep cut to its key lending rate when it sets monetary policy on Tuesday.
Bond prices rose ahead of the central bank's announcement.
The Canadian dollar closed the North American session at US$1.0118, valuing a U.S. dollar at 98.83 Canadian cents, down from US$1.0158, valuing a U.S. dollar at 98.44 Canadian cents, at Friday's close.
Data released by Statistics Canada showed the lofty Canadian dollar, along with the slumping U.S. economy, acted as a drag on exports and slowed annualized economic growth in the fourth quarter to its most sluggish pace since the second quarter of 2003.
The economy grew just 0.8 percent on an annualized basis in the quarter.
For December, deteriorating exports caused gross domestic product to shrink by 0.7 percent, against market forecasts for a 0.2 percent decline, the report showed.
"I know it's a December number, but it was awful and I guess a lot of people are scratching their heads and asking why the Bank of Canada didn't cut by 50 basis points back in January, given all the turmoil going on," said Steve Butler, director of foreign exchange at Scotia Capital.
The numbers up the odds that the central bank will cut its overnight lending rate by 50 basis points to 3.5 percent on Tuesday, Butler said.
The central bank lowered its key rate by 25 basis points in December and January, but a half-percentage point cut would be its biggest cut since late 2001 just after the Sept. 11 attacks in the United States.
A Reuters poll conducted on Feb. 29 showed most of Canada's primary dealers expect a 50-basis-point cut in the overnight rate to 3.50 percent.
The fall in the Canadian dollar marked a sharp turnaround from last week when it hit its highest level in three months given the red-hot prices of many of the key commodities that Canada produces.
Canadian bond prices rallied on widespread expectations for a hefty Bank of Canada rate cut on Tuesday.
"Canadian bonds outperformed the U.S. in the wake of the GDP report this morning," said Mark Chandler, fixed income strategist at RBC Capital Markets.
The two-year bond rose 11 Canadian cents to C$102.58 to yield 2.717 percent. That is its lowest yield since May 2004, and signals that the market expects more Bank of Canada easing after Tuesday's announcement, said Chandler. Bond yields move inversely to bond prices.
The 10-year bond gained 12 Canadian cents to C$102.96 to yield 3.619 percent.
The yield spread between the two- and 10-year bond was 90.2 basis points, up from 86.1 basis points at the previous close.
The 30-year bond edged up 2 Canadian cents to C$115.50 to yield 4.086 percent. In the United States, the 30-year Treasury yielded 4.441 percent.
The three-month when-issued T-bill yielded 2.98 percent, down from 3.08 percent at the previous close. (Editing by Peter Galloway)