* Canadian dollar at C$1.2579 per U.S. dollar, or 79.50 U.S. cents
* Loonie touches its strongest since Aug. 4 at C$1.2558
* Bond prices move lower across much of the yield curve
* 10-year spread vs U.S. Treasuries narrows by 2.5 basis points
By Fergal Smith
TORONTO, Aug 18 (Reuters) - The Canadian dollar rose to a two-week high against its U.S. counterpart on Friday, boosted by data showing an uptick in the rate of underlying inflation and a jump in oil prices, while political uncertainty weighed on the greenback.
Canada's overall annual inflation rate rose to 1.2 percent from June's 20-month low of 1.0 percent, while two of the three measures of core inflation that the Bank of Canada introduced last year saw gains. (the core measures) are trending higher, and this is consistent with the output gap being almost closed," said Jimmy Jean, senior economist at Desjardins Capital Markets.
The output gap is the difference between what an economy produces and its potential production, without overheating.
Strengthening in the domestic economy prompted the Bank of Canada to raise interest rates in July for the first time in nearly seven years.
"People don't believe the Fed (U.S. Federal Reserve) is going to raise rates but are more inclined to believe that the Bank of Canada is going to raise rates," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
The market sees a two-in-three chance of another hike from Canada's central bank in October, overnight index swaps figures show. BOCWATCH
At 4 p.m. EDT (1800 GMT), the Canadian dollar CAD=D4 was up 0.8 percent at C$1.2579 per U.S. dollar, or 79.50 U.S. cents.
The currency's weakest level of the session was C$1.2691, while it touched its strongest since Aug. 4 at C$1.2558.
Adding to support for the loonie, prices of oil CLc1 , one of Canada's major exports, rose 3 percent as U.S. drillers cut rigs and the greenback fell. U.S. dollar .DXY retreated against a basket of currencies as the ouster of White House senior adviser Steve Bannon kept investors jittery about the outlook for President Donald Trump's agenda. the week, the loonie gained 0.8 percent. Still, data from the U.S. Commodity Futures Trading Commission and Reuters calculations showed that speculators have pared bullish bets on the currency.
Canadian dollar net long positions fell to 51,349 contracts as of Aug. 15, after reaching 62,821 contracts a week earlier, the highest since January 2013.
Canadian government bond prices were lower across much of the yield curve, with the 10-year CA10YT=RR falling 19 Canadian cents to yield 1.870 percent.
The gap between the 10-year yield and its U.S. equivalent narrowed by 2.5 basis points to a spread of -32.4 basis points.