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CANADA FX DEBT-C$ hits 2-month low ahead of Bank of Canada policy decision

(Updates to close, adds strategist comments)

* Canadian dollar at C$1.2683, or 78.85 U.S. cents

* Loonie touches its lowest since Aug. 16 at C$1.2692

* Bond prices mostly lower across a steeper yield curve

TORONTO, Oct 24 (Reuters) - The Canadian dollar softened to a more than two-month low against the U.S. dollar on Tuesday as investors braced for the Bank of Canada's latest policy decision on Wednesday. After back-to-back interest rate increases in July and September, the Bank of Canada is widely expected to stay put in October, as economic data shows the pace of growth slowing in the third quarter. Tighter mortgage rules slowing the housing market and uncertainty about the North American Free Trade Agreement add to the uncertain economic outlook. Chances of a rate increase this week have sunk to about 20 percent from nearly 50 percent in mid-September, the overnight index swaps market indicates. The central bank's policy rate sits at 1 percent. "The risk now going into that meeting ... especially among the futures market, is that it's extremely long CAD and that needs to be rectified to a certain degree," said Bipan Rai, executive director and senior macro strategist at CIBC Capital markets. "I think a large part of the moves we've seen since Friday is largely predicated on that." At 4:00 p.m. EDT (2000 GMT), the Canadian dollar stood at C$1.2683, or 78.85 U.S. cents, down 0.3 percent. The currency's strongest level of the session was C$1.2622, while it touched its weakest since Aug. 16 at C$1.2692. Also adding to the pressure was a rebounding U.S. dollar, which pared losses following reports of support from Republican senators for John Taylor as the next Federal Reserve chief. The news offset dwindling hopes that a major U.S. tax overhaul bill will pass. The retreat comes even as prices of oil, one of Canada's major exports, rose after top exporter Saudi Arabia said it was determined to end a supply glut. "The correlation between CAD and crude has broken down, as expected, given the fact that we are more or less in a long term range-bound environment for crude," said Rai. Canadian government bond prices were mostly lower across a

steeper yield curve, with the two-year down 4

Canadian cents to yield 1.496 percent and the 10-year falling 37 Canadian cents to yield 2.069 percent. Canada's Liberal government unveiled a smaller-than-forecast budget deficit for 2017/18 late on Tuesday as it pressed forward with more stimulus spending on families, but did not project the budget would return to balance in the next five years.

(Reporting by Solarina Ho; Additional reporting by Fergal Smith; Editing by Steve Orlofsky and Tom Brown)