* Rally in commodity prices key driver behind C$ rally
* Talk of M&A interest also helps to bolster currency
* Bond prices rattled by talk of recovery in economy
By Frank Pingue
TORONTO, Jan 23 (Reuters) - The Canadian dollar shot to its highest level in more than a week versus the U.S. dollar on Friday, bolstered by a sharp rally in prices for key Canadian exports and speculation of merger-related interest.
Canadian bond prices finished lower across the curve due to a combination of supply concerns and comments from the Bank of Canada earlier this week that the economy would recover faster than many had expected.
The Canadian dollar closed at C$1.2312 to the U.S. dollar, or 81.22 U.S. cents, up from C$1.2537 to the U.S. dollar, or 79.76 U.S. cents, at Thursday's close.
A late-session rally helped power the currency to its highest level since Jan. 14 and allowed the Canadian dollar to exit the week with a 1.4 percent gain. That marked a sharp turnaround from earlier in the week when it was down as much as 2.2 percent.
Canada is a key exporter of oil and gold, so a 4 percent surge in gold prices to break above the $900 an ounce level and a 6 percent jump in oil prices paved the way for the jump.
"What's behind the Canadian dollar's rally is certainly correlated markets ... gold and crude, but certainly the bounce in crude has been favorable to the Canadian dollar," said Jack Spitz, managing director of foreign exchange at National Bank of Canada.
"There are are also rumors of corporate flows that are in the marketplace and yet the fundamentals are still skewed in favor of Canadian dollar weakness."
Early in the session the Canadian dollar turned lower, a move spurred by an inflation report that supported predictions for more Bank of Canada interest rate cuts. Oil prices were also lower early in the session.
Some currency experts suggested the Canadian dollar likely backed away from its session high of C$1.2267 to the U.S. dollar, or 81.52 U.S. cents, because of concern over the weakened state of the global economy and how that could weigh on demand for the commodities that Canada exports.
"The resiliency of this move was somewhat shocking given the backdrop that's going on," said David Watt, senior economist at RBC Capital Markets. "The global economy still doesn't look like it's at a great stage for commodity currencies to do spectacular."
BONDS DROP ON ECONOMIC RECOVERY TALK
Canadian bond prices all ended lower as talk from the Bank of Canada that the economy will surface from this recession faster than it from previous recessions extended a recent bearish tone toward secure assets like government debt.
In a quarterly economic outlook released on Thursday, the central bank said the Canadian economy will shrink during the first half of 2009 before returning to growth in the third quarter, a scenario several experts considered too rosy.
A slide in the bigger U.S. Treasury market also influenced Canadian bonds. Dealers fled U.S. bonds on concerns about the impact of the large amount of new debt that is expected to be issued in the United States in coming years to fund government programs to stimulate the economy.
"The whole MPR update and the somewhat snappy recovery that they are forecasting have been weighing on the Canadian (bond) market," said Mark Chandler, fixed income strategist at RBC Capital Markets.
"At the very long end of the market it's more a perception about supply. Canada was insulated to some degree but it's beginning to work against us as well."
Chandler also said the stimulus measures that are expected to be unveiled next week when Canada's Conservative government unveils its annual budget also weighed on sentiment.
The two-year bond dropped 21 Canadian cents to C$102.70 to yield 1.264 percent, while the 10-year bond fell 63 Canadian cents to C$11.62 to yield 2.826 percent.
The 30-year bond shed 85 Canadian cents to C$123.55 to yield 3.658 percent. In the United States, the 30-year Treasury yielded 3.317 percent. (Editing by Peter Galloway)