* C$ ends at C$1.0217 vs US$, or 97.88 U.S. cents
* Canadian dollar drops 1.3 percent against US$
* Bond prices climb as Italian yields soar (Updates to close, adds comments)
By Jennifer Kwan
TORONTO, Nov 9 (Reuters) - The Canadian dollar posted its biggest loss against the U.S. dollar in just over a week on Wednesday as the euro zone debt crisis and fears that Italy would be forced to seek a bailout heightened risk aversion and prompted a big swing to the safety of the greenback.
Italian borrowing costs reached a breaking point on Wednesday after Prime Minister Silvio Berlusconi's insistence on elections instead of an interim government opened the way to prolonged instability and delays to long-promised economic reforms. [ID:nL6E7M93EM]
"The key drivers started out with Italian yields blowing out past the 7 percent mark and sending the markets into a concerted risk-off mentality that sent equities lower across the board," said Matt Perrier, director of foreign exchange sales, BMO Capital Markets.
The euro fell the most in 15 months against the U.S. dollar, while Canadian and global stocks plunged on fears the country would be forced to seek a bailout that could overwhelm the euro zone's finances and push the region into a recession. [MKTS/GLOB]
"It has been translated into broad-based (U.S.) dollar strength on risk aversion here," Perrier said.
The Canadian dollar CAD=D3 ended the day at C$1.0217 versus the greenback, or 97.88 U.S. cents, dropping 1.3 percent to notch its steepest decline since Nov. 1. On Tuesday, the currency finished at C$1.0082 against the U.S. dollar, or 99.19 U.S. cents.
Despite this, Perrier said the Canadian dollar was "holding in quite well."
Analysts say the currency looks set to outperform its commodity-linked peers and the euro in the near term, citing Canada's proximity to the still-expanding U.S. economy and the fact its interest rates are unlikely to fall. [ID:nN1E7A81FZ]
But on Wednesday, Bank of America Merrill Lynch broke with other Canadian primary dealers to predict the Bank of Canada would cut its key policy rate back to 0.25 percent next year from 1 percent now. BoA Merrill predicted the move would come in the first quarter of 2012, driven by the impact of the euro zone debt crisis. [FXN]
A Reuters poll taken on Nov. 4 showed none of Canada's 12 primary dealers expect a cut, with 7 of 12 predicting a rate hike next year. [CA/POLL]
Canadian government bond prices rose alongside U.S. Treasuries as investors sough safe-haven assets.
The two-year bond CA2YT=RR was up 18 Canadian cents to yield 0.905 percent, while the 10-year bond CA10YT=RR climbed 77 Canadian cents to yield 2.094 percent.
Elsewhere, Canada's sale of two-year government bonds met with healthy demand on Wednesday as investors flocked to the safety of government debt due to concerns about a deepening euro zone crisis. [ID:nN1E7A81HL]
"There's a little more heightened risk aversion today than there was yesterday and as a result people were covering shorts in the sector," said Ian Pollick, fixed income strategist at RBC Capital Markets. (Editing by Rob Wilson)