* C$ rises as high as C$0.9492, or $1.0535
* Bank of Canada holds key interest rate at 1 pct
* BoC tone more hawkish, hints it will resume hiking
* Bonds drop on higher likelihood of rate hike soon
By Solarina Ho
TORONTO, July 19 (Reuters) - The Canadian dollar powered to its highest level against the U.S. dollar in 2-1/2 months on Tuesday after the Bank of Canada held its key interest rate steady, but hinted more firmly than before that it would resume increasing rates.
The central bank held its overnight rate at 1.0 percent, but said core inflation will reach the bank's 2 percent target earlier than expected as it sees Canadian economic growth accelerating in the second half of 2011, in contrast to rising risks abroad. [ID:nN1E76I045]
"There is a vague shift in the tone of the statement, toward slightly more hawkish," said Camilla Sutton, chief currency strategist, Scotia Capital. "So in terms of what the market will price in, (the statement) will probably pull forward their expectations for interest rate hikes ever so slightly."
Overnight index swaps, which trade based on expectations for the key central bank policy rate, showed investors placing a slightly higher bet on the likelihood of a rate hike later this year. But the market still has not fully priced in a 25-basis-point hike until next year. BOCWATCH
At 9:31 a.m. (1331 GMT), the currency CAD=D4 was at C$0.9494 to the U.S. dollar, or $1.0533, up from C$0.9551 to the U.S. dollar just before the rate decision, and up from Monday's North American session close of C$0.9589, or $1.0429. It rose as high as C$0.9492, or $1.0535, its highest level since May 3.
"The early response is that the markets are seeing (the statement) as at least modestly more hawkish than expected," said Doug Porter, deputy chief economist at BMO Capital Markets.
The Bank of Canada will give a fuller view of its thinking in its quarterly Monetary Policy Report on Wednesday.
The Canadian dollar also benefited from a market rebound on Tuesday in risk assets after a selloff prompted by the debt crises in Europe and the United States, and a weak economy in the United States, Canada's biggest trading partner.
The European and U.S. problems have been seen as a threat to economic growth in Canada, but the central bank maintained its projection that the economy would return to full capacity by the middle of 2012 and that inflation would remain well anchored.
Canadian government bond prices were lower across the curve, reflecting the possibility that interest rate hikes may come before year-end.
The two-year bond CA2YT=RR, which is more sensitive to Bank of Canada interest rate moves, was down 16 Canadian cents to yield 1.468 percent, while the 10-year bond CA10YT=RR gave back 39 Canadian cents to yield 2.918 percent. (Additional reporting by Trish Nixon, Ka Yan Ng and Claire Sibonney; editing by Peter Galloway)