* Canadian dollar at C$1.2556, or 79.64 U.S. cents
* Domestic retail sales rise more than expected in May
* Chances rise of a second interest rate hike in October
* Bond prices mixed across the yield curve
TORONTO, July 21 (Reuters) - The Canadian dollar strengthened against its U.S. counterpart on Friday, boosted by stronger-than-expected retail sales data that supported prospects for another interest rate increase by the Bank of Canada. Retail sales rose by 0.6 percent in May from April to hit a record C$48.91 billion, Statistics Canada said, much greater than the 0.2 percent advance forecast by analysts in a Reuters poll. Sales volumes grew by 1.1 percent. A separate report showed Canada's annual inflation rate slowed to a 20-month low of 1.0 percent in June, well below the Bank of Canada's 2.0 percent target, although core measures showed signs of strength. "The Bank of Canada can be expected to pursue that normalization (in rates) it started in July," said Jimmy Jean, senior economist at Desjardins. The central bank raised interest rates last week for the first time since 2010. Chances of a second rate hike in October climbed above 70 percent from a roughly two-thirds chance before the economic reports, data from the overnight index swaps market shows. Still, Canada's real return bonds and flat yield curve are signaling the Bank of Canada will not reach its 2 percent inflation target any time soon. That suggests the central bank is unlikely to pull off more than one more rate hike even as money markets see further tightening into 2018.
At 9:21 a.m. ET (1321 GMT), the Canadian dollar was
trading at C$1.2556 to the greenback, or 79.64 U.S. cents, up 0.3 percent. The currency traded in a range of C$1.2546 to C$1.2607. On Thursday, it touched its strongest since early May 2016 at C$1.2541. The loonie rose even as prices of oil, one of Canada's major exports, fell after a consultancy report forecast a rise in OPEC production for July.
U.S. crude prices were down 0.60 percent at $46.64 a
barrel. Canadian government bond prices were mixed across the yield
curve, with the two-year down 0.5 Canadian cent to yield 1.245 percent and the 10-year climbing 4
Canadian cents to yield 1.878 percent. The gap between the 2-year yield and its U.S. equivalent narrowed by 1.1 basis points to a spread of -10.8 basis points, its narrowest since early July 2016.
(Editing by Bernadette Baum)