* Canadian dollar at C$1.2623, or 79.22 U.S. cents
* Loonie touches its weakest since Aug. 31 at C$1.2630
* Bond prices mixed across steeper yield curve
* Canadian yields fall further below U.S. yields
By Fergal Smith
TORONTO, Oct 20 (Reuters) - The Canadian dollar suffered its biggest drop in nine months against the greenback on Friday, after domestic data showing a drop in retail sales added to expectations that the Bank of Canada will leave interest rates on hold next week.
Retail sales fell by 0.3 percent in August from July, pointing to a slowdown in growth after a hot first half of the year. data showed that Canada's annual inflation rate increased to 1.6 percent in September from 1.4 percent in August, matching forecasts, but well below the Bank of Canada's 2 percent target.
Perceived chances of another rate hike at next week's policy decision slipped to less than 20 percent from 27 percent before the data, the overnight index swaps market indicated. BOCWATCH
The central bank hiked in July and September, the first rate increases since 2010. But tougher new rules on mortgage lending, finalized this week by Canada's banking regulator, could add to the slowdown in Canada's previously red-hot housing market.
The Office of the Superintendent of Financial Institutions has given the Bank of Canada scope to ease the pace of rate hikes, said Brad Schruder, director of corporate sales and structuring at BMO Capital Markets.
At 4 p.m. EDT (2000 GMT), the Canadian dollar CAD=D4 was trading at C$1.2623 to the greenback, or 79.22 U.S. cents, down 1.1 percent, its biggest drop since Jan. 18.
The currency touched its weakest since Aug. 31 at C$1.2630. For the week, it fell 1.3 percent.
Losses for the loonie on Friday came as the U.S. dollar .DXY made its biggest daily gain in a month, as progress on U.S. tax reforms raised prospects of a fiscal lift to the economy. have trimmed bullish bets on the loonie, data from the U.S. Commodity Futures Trading Commission and Reuters calculations showed.
As of Oct. 17, Canadian dollar net long positions had dipped to 75,086 contracts from 76,392 a week earlier.
U.S. crude CLc1 prices settled 18 cents higher at $51.47 a barrel. Oil is one of Canada's major exports. government bond prices were mixed across a steeper yield curve, with the two-year CA2YT=RR up 2 Canadian cents to yield 1.475 percent and the 10-year CA10YT=RR falling 14 Canadian cents to yield 2.03 percent.
Canadian yields fell further below yields on U.S. debt. The 10-year spread widened 4.5 basis points to a spread of -35.3 basis points, its biggest gap since Aug. 16.