* Canada's recovery likely to be dampened by weak U.S.
* Recoveries also faltering in non-U.S. trade partners
* Outlook on rate hikes now more tentative
* Exporters seek alternative markets such as China (Adds recent U.S. data in fourth paragraph. In U.S. dollars unless noted)
By Louise Egan
OTTAWA, July 7 (Reuters) - Euphoria in Canada over the country's breakneck recovery has given way to a sinking realization that it was too good to last, with a faltering U.S. economy now seen dragging on growth.
Two straight quarters of sizzling growth rates astounded even the most bullish economists and prompted the Bank of Canada to start raising interest rates in June from emergency low levels. The feeling was that strength in the domestic housing market and healthy consumer spending were enough to offset headwinds from abroad.
But a recent string of weak U.S. data has raised doubts about the global economy's ability to stand on its own feet without the help of government stimulus. For Canadians, it serves as a blunt reminder that their fate is tied to that of their neighbor, buyer of three-quarters of their exports.
Data out on Tuesday showed U.S. service sector growth in June was the slowest since February. This follow a report on Friday that showed overall U.S. employment fell last month for the first time this year. [ID:nN06102990]
Companies that thrive on sales to the American consumer say it's starting to feel like a recession all over again.
"Since early April I've been hearing ... that they're once again seeing their customers delaying payment, having difficulties financing their orders, and postponing orders. Those were some of the signs that we saw in the latter part of 2007 and first half of 2008," said Jayson Myers, president of Canadian Manufacturers and Exporters, an industry group.
The Bank of Montreal cited "a potential double-dipping, deflation-prodding U.S. downturn" as one reason Bank of Canada Governor Mark Carney will have to cut his growth forecasts later this month.
In a report this week, BMO tweaked its outlook to allow for more pauses in the rate-hiking cycle this year and next. It sees second-quarter growth of 2.7 percent, annualized, versus the central bank's 3.8 percent estimate.
"U.S. demand just really isn't as buoyant as we had hoped, and that the Bank of Canada had hoped. That makes them think twice about hiking as consistently as what markets were thinking a couple of months ago," said BMO economist Benjamin Reitzes.
Just one month ago, even after Carney warned that further tightening was not "preordained", markets were pricing in an 82 percent chance of another quarter-point rate hike on July 20 after the bank lifted its key rate to 0.5 percent on June 1.
Following news the Canadian economy stalled in April, that
expectation -- as indicated by the yields on overnight index
swaps -- dipped to below 50 percent. It now stands at nearly 60
percent.
Even monetary hawks who thought the bank was too slow to lift rates in the face of robust growth and rising inflation, now say the foot-dragging may not have been such a bad thing.
"I wished they had started getting back to normal a little bit earlier, so maybe this slowdown in the United States is going to make it less urgent to do that so it may come out all right in the end," said David Laidler, professor emeritus at the University of Western Ontario.
PANDA DIPLOMACY
The challenge for Canada is to figure out how to keep growing its export economy even if Americans buy fewer of its products -- a cause that Carney frequently champions.
If anyone doubted Ottawa's resolve to tap fast-growing markets like China, they only had to look as far as their televisions on Monday, where Governor General Michaelle Jean was seen cuddling baby pandas on a visit to China in the hope that Beijing would sent two of them to Canadian zoos.
China often uses the gift of pandas as a diplomatic tool to signal warming relations. But after President Hu Jintao met Prime Minister Stephen Harper in Ottawa last month there were signs Canada will get more than symbolism. Beijing eased import restrictions on Canadian beef and said it wants to double bilateral trade to $60 billion by 2015.
Ottawa also touts free trade negotiations with the European Union and others as pathways to a more resilient economy.
It's not just official policy. Businesses are finding it a sensible and profitable strategy too. "There seems to me to be a new openness to dealing in non-traditional markets. That's the kind of thing that a crisis produces," said Peter Hall, chief economist at the Canadian government's export agency.
Still, breaking into non-U.S. markets does not happen overnight and to further complicate things the economic recoveries in Europe and even high-growth Asia are not looking as certain as they once were.
Just as Canadian companies are coming to terms with the need to seek growth opportunities outside North American, there are fewer places to turn to.
"As manufacturers have tried to diversify more and find new customers, risk has also diversified," said Myers.
"The bet that emerging economies, and especially China and India, will continue to grow at such strong growth rates ... that's the assumption that's now being questioned." (Editing by Jeffrey Hodgson and Rob Wilson)