(Adds details, updates trading)
By Frank Pingue
TORONTO, Jan 22 (Reuters) - The Canadian dollar rose off a four-month low versus the U.S. dollar on Tuesday as a surprise rate cut by the U.S. Federal Reserve and a smaller cut by the Bank of Canada put the interest-rate spread in Canada's favor.
Domestic bond prices handed back earlier gains and slipped into negative territory, due mainly to the Bank of Canada rate decision which didn't deliver the 50-basis-point cut that many in the market had anticipated.
At 10:50 a.m. (1550 GMT), the Canadian unit was at C$1.0243 to the U.S. dollar, or 97.63 U.S. cents, up from C$1.0329 to the U.S. dollar, or 96.81 U.S. cents at Monday's close.
The Canadian dollar rose to C$1.0250, or 97.56 U.S. cents, around 8:20 a.m. after the Fed slashed rates by 75 basis points to 3.50 percent ahead of its policy meeting next week. But it handed back the gains within 10 minutes.
Shortly after, the Bank of Canada cut its key lending rate by 25 basis points to 4.00 percent at its scheduled monetary policy announcement, sending the Canadian dollar back higher.
"The Fed's aggressively cutting interest rates and the Bank of Canada is modestly cutting interest rates, so now the positive rate spread story is there," said David Watt, senior currency strategist at RBC Capital Markets.
"But the reaction of the Canadian dollar over the next few days is going to depend on whether or not we get some stability and confidence returning to the market."
Heading into the North American session, the Canadian dollar had been under pressure, given concerns about a possible global economic slowdown and talk that the Bank of Canada might cut rates by a bigger-than-expected 50 basis points.
It slipped as low as 96.34 U.S. cents overnight, putting it down 4 percent in January. This follows a banner year in 2007, when the Canadian unit rocketed 17.5 percent higher against the greenback, given a slew of factors including higher commodity prices, foreign takeovers of Canadian firms and a robust domestic economy.
BONDS TURN LOWER
Canadian bond prices handed back all of their early gains as the Bank of Canada rate cut fell short of the 50-basis-point cut that some had called for.
Expectations for a half-percentage-point cut, which were largely responsible for the early rise in bond prices, were fueled further by the Fed's surprise rate cut.
"There was some speculation that the bank would cut rates 50 basis points so that's caused the bond market to weaken," said Sal Guatieri, senior economist at BMO Capital Markets. "So the markets were pumped for a 50-pointer."
Getting lost in the shuffle on Tuesday was a domestic piece of economic data that showed retail sales rose 0.7 percent in November, topping estimates for a gain of 0.2 percent.
The overnight Canadian Libor rate LIBOR01 was at 4.0900, percent, down from 4.2817 percent on Monday.
Monday's CORRA rate CORRA= was 4.2483 percent, down from 4.2582 on Friday. The Bank of Canada published the previous day's rate at around 9:00 a.m. daily.
The two-year bond was down 6 Canadian cents at C$102.01 to yield 3.124 percent. The 10-year bond dropped 54 Canadian cents to C$102.45 to yield 3.813 percent.
The yield spread between the two-year and 10-year bond was 68.0 basis points, up from 65.2 points at the previous close.
The 30-year bond decreased C$1.14 to C$114.76 to yield 4.127 percent. In the United States, the 30-year Treasury yielded 4.306 percent.
The three-month when-issued T-bill yielded 3.54 percent, unchanged from the previous close. (Editing by Bernadette Baum)