* Canadian dollar rises 0.5 percent against the greenback
* Canada's economy grows 0.2 percent in July
* Bond prices trade mixed across a flatter yield curve
* Canada-U.S. 2-year spread narrows by 2.6 basis points
By Fergal Smith
TORONTO, Sept 28 (Reuters) - The Canadian dollar notched its largest gain in two months against the greenback on Friday after data showing faster-than-expected growth of the domestic economy boosted expectations of an interest rate hike from the Bank of Canada in October.
At 3:55 p.m. (1955 GMT), the Canadian dollar CAD=D4 was trading 0.9 percent higher at 1.2923 to the greenback, or 77.38 U.S. cents, its biggest since July 20.
It left the loonie as the best performing G10 currency on Friday despite the expected release of the text of the Trump administration's trade agreement with Mexico. For the week, the Canadian dollar was nearly unchanged.
U.S. President Donald Trump, who complained this week that talks to modernize the North American Free Trade Agreement (NAFTA) were moving too slowly, has threatened to leave Canada out of the deal if it does not sign up by Sunday. He has also proposed slapping auto tariffs on Canada. have a lot of uncertainty on trade still," said Nathan Janzen, a senior economist at Royal Bank of Canada. "At the same time, the domestic economic backdrop still looks plenty strong enough to warrant higher interest rates."
Canada's economy grew 0.2 percent in July, stronger than the 0.1 percent increase that analysts had forecast, Statistics Canada data indicated. figures are significant because the Bank of Canada earlier this month forecast that temporary factors would weigh on third-quarter growth.
Chances of an interest rate increase next month by the central bank climbed to more than 80 percent from 77 percent before the data, the overnight index swaps market indicated. BOCWATCH
The Bank of Canada will continue to raise interest rates gradually, Governor Stephen Poloz said on Thursday. price of oil, one of Canada's major exports, rose as U.S. sanctions on Tehran squeezed Iranian crude exports, tightening supply even as other key exporters increased production. crude oil futures CLc1 settled 1.9 percent higher at $73.46 a barrel.
The U.S. dollar .DXY climbed to a two-week peak versus a currency basket as concerns about the Italian budget weighed on the euro. government bond prices were mixed across a flatter yield curve, with the two-year CA2YT=RR down 2 Canadian cents to yield 2.212 percent and the 10-year CA10YT=RR rising 2 Canadian cents to yield 2.421 percent.
The gap between the 2-year yield and its U.S. equivalent narrowed by 2.8 basis points to a spread of 60.7 basis points in favor of the U.S. bond.