UPDATE 4-Canada economy shrinks in August, clouds outlook

Wed Oct 31, 2012 1:24pm EDT

* Growth unexpectedly contracts 0.1 percent from July

* Mining, oil and gas, manufacturing decline most

* Analysts see broad weakness, cutting forecasts

* Bank of Canada seen on hold for longer

By Louise Egan

OTTAWA, Oct 31 (Reuters) - The Canadian economy shrank in August for the first time in six months, an unexpected contraction that pointed to a sharp slowdown in third-quarter growth and reinforced the Bank of Canada's message that interest rate hikes are less imminent.

The 0.1 percent contraction from July reflected broad weakness across most industries as well as temporary shutdowns at some oil and mining sites, Statistics Canada said on Wednesday.

Analysts revised forecasts lower, noting economic pressures that went beyond oil and mining. The Canadian dollar fell.

The Canadian economy recovered from the global recession more quickly than most, and is expected to grow at slightly more than 2 percent this year, according to forecasts that Finance Minister Jim Flaherty said on Wednesday were still valid.

But the outlook is shaky due to the choppy U.S. recovery and the European debt crisis, prompting questions about whether August was a blip or the start of a more serious economic downturn.

August's dip was the first monthly contraction in GDP since February. The news comes a week after the central bank said it is still leaning toward raising interest rates, not lowering them, as the economy slowly expands, The policy makes it an outlier among central banks of the world's major economies.

Bank of Canada Governor Mark Carney has signaled since April that he wants to increase the benchmark overnight lending rate after a two-year freeze. But last week he softened his tone and said rate hikes were "less imminent." [ID: nL1E8LO790]

"This report will further lead markets to question the BoC's hiking bias even as it went relatively more dovish than previously," said Holt and Zigler.

Overnight index swaps, which trade based on expectations for the central bank's key policy rate, showed that after the announcement traders pulled their bets on the possibility of a rate hike in late 2013.

The Canadian dollar weakened to below parity with the U.S. dollar after the data was released, sliding to C$1.0002 to the U.S. dollar, or $0.9998, compared with C$0.9985 just before the data and C$0.9993, or $1.0007, at Tuesday's North American close.

Canadian government bond prices turned positive, especially at the front end of the curve, and outperformed U.S. Treasuries.

A BLIP?

There are mixed views on whether the third quarter sluggishness was temporary.

Statscan said slowdowns due to scheduled maintenance work at some oil and mining sites were partly to blame for the downturn in August, along with a slump in manufacturing.

Output in the mining industry slid 2.8 percent in August while oil and gas extraction slumped 0.4 percent. The manufacturing sector slid 0.6 percent.

But economists argued that the economy had stalled more broadly, with 10 of 18 industries reporting declines, and said they had expected less impact from the maintenance shutdowns.

"There are too many negatives in this report to dismiss the headline weakness as being attributable to just temporary disruptions in some sectors," said Derek Holt and Dov Zigler of Scotia Capital.

Doug Porter, deputy chief economist at BMO Capital Markets, agreed. "We can't brush this off as driven by special factors," he said.

Flaherty was more sanguine. "We're going to see some variations, but overall, for the year we are on track with GDP growth," he told reporters.

Flaherty expects 2.1 percent growth this year, based on the average forecast of private sector economists his office surveyed this month.

The Bank of Canada has also suggested the third quarter was an anomaly. Last week it halved its forecast for third-quarter growth to an annualized 1 percent, but predicted a rebound to 2.5 percent growth in the fourth quarter and average growth of more than 2 percent through 2014.