By John McCrank
TORONTO (Reuters) - Fears that demand for commodities will wane if U.S economy slides into recession prompted a return to risk aversion in the markets, knocking the Canadian dollar to it's lowest close against the greenback in nearly five weeks.
Domestic bond prices, which have rallied strongly as of late on a safe-haven bid, fell as investors took profits.
The Canadian dollar closed at 97.60 U.S. cents, valuing a U.S. dollar at C$1.0246, down from 98.37 U.S. cents, or C$1.0166, at Tuesday's close.
The currency fell as low as C$1.0284 to the U.S. dollar, or 97.24 U.S. cents, during the overseas session, its lowest point since September 18.
"The risk aversion theme is more than likely going to continue to set the trend due to the possibility of the U.S. economy going into a recession," said Jack Spitz, director of foreign exchange at National Bank Financial.
Investors tend to unwind carry trades in periods of risk aversion, and the Canadian dollar, which like carry trade currencies is largely commodity driven, is often pulled along.
A carry trade is when investors borrow low-yielding currencies, such as the Japanese yen, or the Swiss franc, to buy higher-yielding assets or currencies. Carry trade profits can be wiped out quickly by market volatility, so they are often unwound in times of risk.
The Canadian dollar was a major beneficiary from the run-up in commodity prices over the past several years, which helped it climb around 60 percent since 2002.
Oil prices CLc1 briefly dropped below $90 due to rising U.S. crude stocks and growing concerns that economic woes could dent demand from the world's biggest energy consumer.
The U.S. consumes nearly three-quarters of Canadian exports, and as the odds of a recession in the U.S. increase, the outlook for Canada sours.
National Bank Financial said in a note that it now sees the chances of a U.S. recession exceeding 70 percent, and that the odds of a Canadian recession are at 30 percent, compared to only 20 percent few weeks ago.
The Bank of Canada makes its next monetary policy announcement on January 22 and most market watchers are expecting a 25-basis-point cut to the overnight rate in order to bolster the economy.
The central bank's overnight rate is currently at 4.25 percent.
Bond prices unwound some of their recent gains as investors pocketed some profits.
New bond issuances by the Bank of Canada over the past couple days also played into the lower bond prices, said Sheldon Dong, fixed income specialist at TD Waterhouse Private Investment.
The two-year bond fell 13 Canadian cents to C$101.71 to yield 3.297 percent. The 10-year bond slipped 38 Canadian cents to C$101.33 to yield 3.829 percent.
The yield spread between the two-year and 10-year bond was 53.2 basis points, down from 54.4 at the previous close.
The 30-year bond declined 77 Canadian cents to C$115.84 to yield 4.070 percent. In the United States, the 30-year Treasury yielded 4.344 percent.
The three-month when-issued T-bill yielded 3.61 percent, down from 3.62 percent at the previous close.
(Editing by Renato Andrade)