* C$ ends session at C$0.9508 to US$, or $1.0517
* Touches C$0.9483 to US$, or $1.0545, highest since May 3
* 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 increase (Updates to close, adds details, comment)
By Solarina Ho
TORONTO, July 19 (Reuters) - The Canadian dollar strengthened to its highest level against the U.S. dollar in 2-1/2 months on Tuesday after the Bank of Canada indicated more firmly than before that it was closer to raising interest rates with the domestic economy seen growing at a healthy pace.
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 domestic economic growth accelerating in the second half of 2011, in contrast to rising risks abroad. [ID:nN1E76I045]
"We saw the reaction with Canada strengthening as it looks like there's some chance of a rate hike before the end of the year," said Shane Enright, executive director, foreign exchange sales, at CIBC Capital Markets.
"If you look at the futures, the market really hadn't priced in that much, so you've seen a little more implied tightening priced into the curve -- not a lot of it into the short date, more into early 2012, but it's been enough to give Canada a little bit of a boost."
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 increase until next year. BOCWATCH
The currency CAD=D4 closed at C$0.9508 to the U.S. dollar, or $1.0517, up from Monday's North American close of C$0.9589, or $1.0429. It rose as high as C$0.9483, or $1.0545, its highest level since May 3.
The Bank of Canada will give a more complete view of its thinking in its quarterly Monetary Policy Report on Wednesday.
Enright also noted that positive earnings, which bolstered equity markets, also lent positive sentiment to the currency.
"The combination of the two things have taken the Canadian dollar stronger: Signs of slightly more intent from the Bank of Canada and stronger equity markets," said Enright.
Market watchers will be parsing the central bank's report on Wednesday as well as inflation and retail sales data on Friday for further direction. Primary dealers could re-evaluate their targets for the Bank of Canada's first rate hike following the events. <CA/POLL>
The European and U.S. debt crises, and the soft economy in the United States, Canada's biggest trading partner, are expected to otherwise dominate the currency's direction until Friday's data.
The broader global risks 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 stable.
"U.S. growth was revised lower and the risk around sovereign debt in Europe has increased significantly. We view these international headwinds as tying the Bank's hands for now," David Tulk, chief Canada macro strategist at TD Securities, wrote in a note.
Canadian government bond prices were generally lower across the curve, reflecting the possibility that interest rate increases may come before year-end.
The two-year bond CA2YT=RR, which is more sensitive to rate moves, was down 19 Canadian cents to yield 1.483 percent, while the 10-year bond CA10YT=RR gave back 20 Canadian cents to yield 2.897 percent. (Editing by Rob Wilson)