* Canadian dollar gains 1.3 percent versus greenback
* Domestic inflation eases sharply in October
* Bonds unwind as stock market rallies
By Cameron French
TORONTO, Nov 21 (Reuters) - The Canadian dollar rose for the first time in four sessions on Friday, helped by stronger commodity prices and rallying stock markets, which took the shine off the U.S. dollar's safe-haven status.
Canadian bond prices gave back some of their recent gains as stocks climbed, while dealers looked past weak October inflation data that seemed to raise the chances of more Bank of Canada interest rate cuts.
The currency finished the session at C$1.2772 to the U.S. dollar, or 78.30 U.S. cents, up from C$1.2935 ,or 77.31 U.S. cents, at Thursday's close.
Coming off a three-week low in the previous session, the rise in typically thin Friday trading was not unexpected, said David Watt, senior currency strategist at RBC Capital Markets.
"It's not that much of a surprise, if you look at technical indicators," he said.
"Given that there didn't seem to be much reason for equity markets to stage such a rapid rally, it's likely going to be a situation next week where we'll see equity markets testing lows and the (U.S. dollar versus the Canadian dollar) testing highs."
Canada's main equity index rallied 5.6 percent, following a 9 percent drop on Thursday.
The Canadian dollar has closely followed the equity market in recent weeks, as steady stock market losses have prompted risk-averse investors to embrace the greenback.
As well, the loonie's close correlation with commodity prices has hurt it as metals and energy prices have plunged.
Oil prices rose, but ended below the key $50 a barrel level, while gold soared 7 percent to rise above $800 an ounce for the first time in more than a month.
Canadian bond prices sold off, particularly on the long end of the yield curve, rebounding from recent sharp gains as funds were shifted to rallying stock markets.
The decline came despite soft inflation data that would normally be positive for bond prices, as it appeared to clear the way for the Bank of Canada to cut interest rates again without fears of prices getting out of control.
Canada's annual inflation rate in October eased more than expected to 2.6 percent from 3.4 percent in September. Analysts in a Reuters poll had forecast a rate of 3.1 percent.
"The market is already in that deflationary mind-set, so it didn't adjust all that much in response to those figures, though perhaps it helped Canada outperform the U.S. in bonds," said Eric Lascelles, chief economics and rates strategist at TD Securities.
"It really is a response to quite a pop in the stock market today. And... if you take the big picture view, you do still note that bonds have rallied quite substantially over the span of the week."
The Bank of Canada's overnight rate is currently 2.25 percent, after cuts totaling 225 basis points since December 2007.
The Canadian overnight Libor rate LIBOR01 was 2.4833 percent, down from 2.500 percent on Thursday.
Thursday's CORRA rate CORRA= was 2.2437 percent, up slightly from 2.2413 percent on Wednesday. The Bank of Canada publishes the previous day's rate at around 9 a.m. daily.
The two-year bond eased 6 Canadian cents to C$101.86 to yield 1.812 percent. The 10-year bond slid 90 Canadian cents to C$106.30 to yield 3.466 percent.
The yield spread between the two-year and 10-year bond was 169 basis points, down from 172 at the previous close.
The 30-year bond shed C$1.98 to C$116.02 to yield 4.047 percent. In the United States, the 30-year treasury yielded 3.685 percent. (Additional reporting by John McCrank; editing by Rob Wilson)