UPDATE 2-Auto slump hits Canada factory sales in March

(Adds analysts, market reaction)

By Louise Egan

OTTAWA, May 15 (Reuters) - The ailing U.S. economy and an ongoing slump in the auto industry caused an unexpectedly sharp 1.6 percent drop in Canadian manufacturing sales in March after two months of gains, Statistics Canada said on Thursday.

The report strengthened the case for the Bank of Canada to cut interest rates again, showing the weakness in March was spread across 18 of 21 industries and in constant dollars sales fell 3 percent.

"With the substantial drop in real shipments during the month, the manufacturing sector will be a source of significant drag for Canadian economic activity in March and the first quarter," said Millan Mulraine, economics strategist at TD Securities.

Analysts surveyed by Reuters had forecast, on average, a 0.2 percent rise in manufacturing sales in the month. Statscan revised down the February sales gain to 1.3 percent from 1.6 percent.

The Canadian dollar fell immediately after the report, touching a low of C$1.0025 to the U.S. dollar, or 99.75 U.S. cents from C$1.0043 to the U.S. dollar at Wednesday's close. It then crept back up past parity with the greenback on lofty oil prices.

Mulraine said gross domestic product now appears likely to contract in March for a second straight month and that the first-quarter growth may fall below the Bank of Canada's projection of 1 percent annualized.

Canadian auto manufacturers -- the hardest hit by the weakening U.S. economy -- were further hampered by labor disputes in U.S. factories that supply car parts, Statscan said. U.S. consumers' shrinking appetite for new cars and rising energy prices also curbed activity in the sector where another plant closure was announced this week by GM Canada (GM.N: Quote, Profile, Research, Stock Buzz).