By Leah Schnurr
TORONTO (Reuters) - The Canadian dollar firmed on Monday after data showed the economy was slightly stronger than expected in July, though investors had their attention south of the border where the clock was ticking to avoid a U.S. federal government shutdown.
The Canadian economy grew at a 0.6 percent rate in July, rebounding from a contraction the previous month as the recovery was hurt by flooding in Alberta and a construction worker strike in Quebec.
Even with the improvement, however, the economy remains well below the central bank's estimate of the potential growth in output.
"Basically this was just a mirror image of the June decline," said Doug Porter, chief economist at BMO Capital Markets in Toronto. "The broader story is when we look past those two volatile months, the economy is still just grinding ahead at a relative sluggish pace."
The Canadian dollar was at C$1.0289, or 97.19 U.S. cents, stronger than Friday's close of C$1.0303, or 97.06 U.S. cents. The loonie had firmed to a session high of C$1.0276 shortly after the data was released, marking its highest level in nearly a week.
The looming possibility of a federal government shutdown in the United States held markets' attention. If a stop-gap spending bill for the new fiscal year is not passed before midnight on Monday, government agencies and programs deemed non-essential will begin closing their doors for the first time in 17 years.
Investors are concerned about the impact such a shutdown would have on the still-fragile U.S. economic recovery. The uncertainty pushed the greenback down 0.5 percent against a basket of currencies <.DXY>.
The political battle also increased concerns about lawmakers' ability to reach a deal to raise the debt ceiling by mid-October. Failure to do so could cause the United States to default on some payment obligations.
"The implications of a default on U.S. debt will have a far more drastic effect on the market's psyche, and even though the risk of default is minor, the ramifications of continued saber-rattling from both sides of the aisle will be heightened volatility across all markets and asset classes," Scott Smith, senior market analyst at Cambridge Mercantile Group in Calgary, wrote in a note.
Prices for Canadian government bonds were higher across the maturity curve. The two-year bond was up 1.7 Canadian cent to yield 1.193 percent and the benchmark 10-year bond rose 10 Canadian cents to yield 2.547 percent.
(Editing by Nick Zieminski)