Canadian dollar up over a cent as markets rally

* Canadian dollar up 1.1 pct on day, 1 pct for week

* U.S. officials to take action on toxic U.S. debt

* Bond prices drop sharply as safe-haven bid unwinds

TORONTO, Sept 19 (Reuters) - The Canadian dollar rose to its highest point in three weeks against the U.S. dollar on Friday, gaining support from rallying commodity prices on the back of plans for a comprehensive package to sop up the toxic debt that has been clogging U.S. financial and money markets.

Canadian bond prices tumbled on a sharp unwinding of the recent safe-haven bid for government debt.

The Canadian dollar ended the North American session at C$1.0500 to the U.S. dollar, or 95.24 U.S. cents, up from C$1.0618 to the U.S. dollar, or 94.18 U.S. cents, at Thursday’s close.

The currency gained 1 percent for the week after a soft start as markets reeled from the bankruptcy filing of Lehman Brothers Holdings Inc LEH.NLEHMQ.PK, which failed to finance risky real estate bets. The sale of Merrill Lynch MER.N and a bailout of American International Group AIG.N followed, freezing up credit markets.

“A few days ago we were looking over a cliff and what we saw was a situation similar to Japan in the 1990s unfolding for the U.S. economy,” said Michael Gregory, senior economist at BMO Capital Markets.

“Now we are in a position where we are far away from that and we will see, hopefully this spring, signs of stronger growth and resumed credit creation in the economy.”

News that U.S. Treasury Secretary Henry Paulson and U.S. Federal Reserve Chairman Ben Bernanke plan to work with Congress on a comprehensive plan to deal with toxic bank assets clogging the financial system led to huge rallies on stock markets.

The gains were extended after the Fed said it would provide loans to banks and institutions for purchases of high-quality asset-backed commercial paper from money market funds.

The stronger equities spurred a rally in commodity prices as demand was seen strengthening, while it weakened the U.S. dollar, which had been bought recently as a safe haven currency, said Matthew Strauss, senior currency strategist at RBC Capital Markets.

More than 50 percent of Canadian exports are commodities.

Despite the strength against the greenback, the Canadian dollar was weaker against most other major currencies.

“The gain against the U.S. dollar came about thanks to higher commodity prices, but we couldn’t escape the broader theme of being classified as a North American currency,” Strauss said.


Canadian bond prices dropped sharply as the unwinding of the safe-haven bid that had been boosting the market continued.

The 10-year bond had its biggest one-day fall since 2004, while the two-year bond fell the most in almost a month.

“It’s basically been a change in perception,” said BMO’s Gregory.

“I think the bond market does not believe central banks necessarily have to cut interest rates as aggressively, if at all in the face of the credit squeeze anymore.”

There was no economic data in Canada on Friday, but next week starts off with a couple of key indicators, with retail sales numbers for July on Monday and inflation data for August on Tuesday.

The two-year bond fell 80 Canadian cents to C$99.70 to yield 2.892 percent, while the 10-year dropped C$1.60 to C$104.35 to yield 3.710 percent.

The yield spread between the two-year and 10-year bond was 79.4 basis points, down from 81.9 basis points at the previous close.

The 30-year bond tumbled C$2 to C$114.40 for a yield of 4.137 percent. In the United States, the 30-year Treasury yielded 4.406 percent.

The three-month when-issued T-bill yielded 2.27 percent, up from 1.50 percent at the previous close. (Editing by Peter Galloway)