Sept. 7 (Bloomberg) -- Canadian bonds fell after the central bank raised interest rates for the first time since October and said the impact of Hurricane Katrina on Canada's economy will ``probably be modest.''

Traders interpreted the comments to mean more rate increases are ahead, damping the appeal of fixed-income investments. Ten-year bonds declined the most in two months. The currency was little changed, after earlier rising.

The bank ``sees balanced risks in 2006, suggesting that nothing that they've seen of late has been particularly worrisome to them,'' said T.J. Marta, senior currency strategist at RBC Capital Markets in New York.

The two-year bond yield rose 6 basis points to 3.04 percent after having increased by 8 basis points yesterday, and the 10- year yield rose 9 basis points to 3.87 percent. Bond prices and yields move in the opposite direction. A basis point is 0.01 percentage point.

Canada's dollar was at 84.05 U.S. cents at 2:15 p.m. in Toronto, from 84.09 U.S. cents late yesterday. Earlier, it was higher against all 16 most actively-traded currencies tracked by Bloomberg. One U.S. dollar buys C$1.1897.

Bank of Canada policy makers raised its target rate to 2.75 percent from 2.50 percent. RBC expects the bank will increase the rate 50 basis points more this year and another 75 basis points through the first half of 2006.

The central bank said the economy is operating close to its capacity and monetary policy is ``still stimulative'' suggesting more rate increases to come. The bank's overnight rate target is below the average of 3.85 percent during the past 10 years.

`Remarkably Low' Rates

``Canadian interest rates are remarkably low by most definitions,'' said Eric Lascelles, economist at Toronto- Dominion Bank. He expects the bank to hold the overnight rate steady in October and raise it by 25 basis points in December.

Higher rates drive up bond yields and depress the market price of existing bonds as investors perceive less value in their fixed-income payments based on previous, lower rates.

The price of the two-year bond, which pays 3 percent coupon interest and matures in June 2007, fell 9 cents to C$99.93. The 10-year bond fell 71 cents to C$105.07, the biggest drop since July 4, and the largest two-day decline in two months.

Canadian bonds underperformed U.S. Treasuries, with Canada's 10-year bond yielding 26 basis points less than comparable Treasuries and the two-year bond yield gap is 79 basis points. The gap in 10-year yields was 31 basis points yesterday.

``Today's interest rate increase will help to promote a balance between aggregate demand and supply in the economy and keep inflation on target over the medium term,'' the Bank of Canada said.

Hurricane's Effect

Hurricane Katrina will create a ``temporary spike'' in Canadian inflation as energy prices surge, and slow U.S. economic growth for the rest of this year before it rebounds in 2006, the bank said in its statement.

All 32 economists polled by Bloomberg expected a rate increase today. The bank's next rate-setting meetings are Oct. 18 and Dec. 6.

Canada's economy grew at a faster-than-expected 3.2 percent annual pace in the second quarter, beating all but one of the 23 estimates collected by Bloomberg. It also exceeded the central bank's estimate of 2.3 percent growth.

``Despite some market concerns over past few days addressing the hurricane, the net impact on Canadian economy according to the Bank of Canada is likely to be limited,'' Toronto-Dominion's Lascelles said.

Lagging Fed's Pace

This was the first time the Bank of Canada changed the target rate since last October. By contrast, the Federal Reserve since June 2004 has raised its target ten times to the current 3.50 percent, from 1 percent, which was the lowest since 1958.

The Canadian dollar gained 1 percent last week as surging energy prices boosted expectations for economic growth and demand for oil in Canada, holder of the second-largest pool of reserves after Saudi Arabia. The currency reached 85.31 U.S. cents on Aug. 31, the highest since Nov. 26.

``The bias to tighten remains firmly in place,'' wrote economists at BMO Nesbitt Burns in Toronto in a note to clients. ``and we continue to look for another rate hike next month, depending on the data.''

Yields on bankers' acceptance contracts due Dec. 19, a Canadian interest-rate futures contract, rose 7 basis points to 3.02 percent. The yield is up 17 basis points this week. A basis point is 0.01 percentage point.

Bankers' acceptance contracts settle at Canada's three- month lending rate, which has averaged 16 basis points above the central bank's current rate target since Bloomberg started tracking the gap in 1992. The yield would have to rise to more than 3.12 percent to show traders are expecting another rate increase to 3 percent by year-end.

Traders have priced in about a 50 percent chance of another 25 basis-point rate increase by year-end, with ``a higher probability for a December hike than October,'' said Michael Le, fixed-income strategist at JP Morgan Securities Canada.

To contact the reporter on this story: Dawn Desjardins in Toronto at Ddesjardins1@bloomberg.net

Last Updated: September 7, 2005 14:18 EDT