* C$ drops as low as C$1.0528 after Canadian rate decision
* Statement snuffs out hopes of early rate hikes
* Bond yields drop across curve, outperform U.S. market
By Frank Pingue and Jeffrey Hodgson
TORONTO, Oct 20 (Reuters) - Canada's dollar tumbled nearly 2 U.S. cents on Tuesday after the central bank warned a strong currency was undermining economic recovery and suggested it will not follow Australia in hiking interest rates quickly.
The Bank of Canada's tough language surprised many in the market, forcing them to reverse bets that the currency would extend a double-digit rally to reach parity with the U.S. dollar.
"It was a much more aggressive statement than we've seen in the past," said Matthew Strauss, senior currency strategist RBC Capital Markets.
The currency fell as low as C$1.0528 to the U.S. dollar, or 94.98 U.S. cents, its weakest level since Oct. 9.
The Canadian dollar closed at C$1.0508, or 95.17 U.S. cents, down from C$1.0293 to the U.S. dollar, or 97.15 U.S. cents, at Monday's close.
The pullback for the Canadian dollar comes only days after it rallied to a 14-month high of nearly 98 U.S. cents. It is still up 24 percent from the four-year low it fell to in early March.
In its policy statement, the central bank left its key overnight interest rate steady at a record low 0.25 percent and said a return to economic normalcy would be delayed. [ID:nN19231469]
It also said the current strength of the dollar is expected, over time, to "more than fully offset the favorable (economic) developments since July".
"In June, when they came out quite strongly warning about the adverse impact of the Canadian dollar they only indicated it would just fully offset," Strauss said.
Another drag on the Canadian dollar was a drop in the price of oil, a key Canadian export whose price often dictates the currency's direction. The oil price fell after hitting a one-year high over $80 a barrel. [O/R]
BOND PRICES HIGHER
Canadian bond prices were higher across the curve, boosted by "fairly dovish results from the Bank of Canada," said Sheldon Dong, fixed-income analyst at TD Waterhouse Private Investment.
Bond yields fell as the market, which had started to price in the prospect of early rate hikes, quickly erased thise positions.
The two-year bond CA2YT=RR rose 27 Canadian cents to yield 1.497 percent, down from 1.618 percent before the Bank of Canada statement. Swap markets also showed a drop in rate hike expectations. BOCWATCH
Canadian bonds outperformed U.S. Treasuries, which extended gains on weaker-than-expected U.S. economic data. [US/]
The yield on the two-year Canadian government bond was about 57 basis points above its U.S. counterpart, down from 66 basis points at the close of trading on Monday.
Dong said weak economic data also supported bond markets.
Canadian data showed wholesale trade fell in August by a steeper-than-expected 1.4 percent from July. [ID:N20424741]
In the United States, softer-than-expected housing starts last month and a drop in prices paid at the farm and factory gate backed views that U.S. interest rates could stay low for a while. [ID:nN20424995] (Editing by Peter Galloway)