By John McCrank
TORONTO, Dec 4 (Reuters) - The Canadian dollar tumbled as much as 1.3 percent against the U.S. dollar after the Bank of Canada cut its key overnight rate for the first time since early 2004 by 25 basis points to 4.25 percent.
Domestic bond prices extended gains on the short end, but lost ground on the long end after the bank's announcement.
At 10:35 a.m. (1535 GMT), the Canadian dollar was at 98.78 U.S. cents, valuing each U.S. dollar at C$1.0124, down sharply from 99.98 U.S. cents, or C$1.0002, at Monday's North American close.
"The combination of lower than expected inflation and rising global economic risks, both because of a slowdown in the U.S. and the renewed credit squeeze, were enough to tip the bank into moving this quickly," said Doug Porter, deputy chief economist at BMO Capital Markets.
A Reuters poll on Friday showed that 8 out of 13 primary securities dealers had expected the central bank to keep rates on hold, though most expected a rate cut in January.
However, the bank held off on promising any future cuts.
"Really, they will now be in data-watching mode like the rest of us," said Porter.
"It seems that if core inflation does remain below 2 percent and we get further signs of weakness from the U.S., the bank could cut further, but certainly, the bank does not seem to be signing up for a prolonged easing cycle at this point."
Since the currency's rapid ascent to a modern-day high of US$1.1039 on Nov. 7, several central bank officials and senior government officials have voiced concern about how its strength could hurt manufacturing and overall economic growth.
Besides falling close to an 11-week low against the greenback after the bank's decision, the Canadian dollar fell to its lowest since May against the euro.
BONDS RALLY ON SHORT END
Short-term Canadian bond prices rallied on the interest rate cut, but the lack of a signal by the central bank to continue easing in the near future may have limited gains.
"To the extent that the market has priced in substantial rate cutting in the next year, I think the bond market move is being tempered by that lack of promise," said Eric Lascelles, chief economics and rates strategist at TD Securities..
The overnight Canadian Libor rate LIBOR01 was at 4.4417 percent, down from 4.5650 percent on Monday.
Monday's CORRA rate CORRA= was 4.5433 percent, down from 4.5525 percent on Friday.
The two-year bond rose 13 Canadian cents to C$101.45 to yield 3.485 percent. The 10-year bond climbed 12 Canadian cents to C$100.99 to yield 3.874 percent.
The yield spread between the two-year and 10-year bond moved to 39.1 basis points from 33.1 at the previous close.
The 30-year bond dropped 41 Canadian cents to C$115.41 to yield 4.095 percent. In the United States, the 30-year treasury yielded 4.331 percent.
The three-month when-issued T-bill yielded 3.91 percent, unchanged from the previous close. (Editing by Bernadette Baum)