A dramatic recovery in financial conditions has modestly improved the economic outlook in Canada, but the economy will continue to be hit by dire conditions in the U.S. over the next two quarters, according to a new report by TD Economics.

The TD Quarterly Economic Forecast, released on Tuesday, calls for a GDP contraction of 2.4% this year, and growth of 1.4% in 2010. It notes that the combination of weak demand for Canadian exports, an appreciating loonie and rising bond yields spell bad news for the domestic economy.

“Canada is hanging on by its fingernails,” said Don Drummond, TD’s chief economist, “but there are painful adjustments ahead. So while the sharpest declines in the economy are behind us, output will continue to decline albeit at a lessening pace and the recovery will initially be tepid.”

Reduced U.S. demand for exports is taking a particularly hefty toll on the domestic economy, the economists noted. They point out that the volume of exports is contracting at an accelerated rate, and is now down 17% from two years ago. The size of the export industry now represents just 33% of the total real economy, down from its traditional weighting of 40%.

The appreciation of the loonie is also impacting the Canadian economy, and the TD economists expect it to hit parity with the greenback by the end of the year. But they believe it will not maintain that strength through 2010, and will therefore have only a brief impact on economic growth.

Another area of concern involves inventory levels, which are far too high, according to the report. Until they are brought in line with demand, the economy will remain highly vulnerable to job losses and production cutbacks, the economists said.

Meanwhile, the economists expect the U.S. economy to contract by 2.8% this year, followed by growth of 1.6% next year.

The report points to some promising signs for the U.S. economy, including an ongoing improvement in credit markets and the fact that stimulus spending is underway.

The report cites mixed evidence that real estate markets in the U.S. are nearing a bottom, noting that there has been some improvement in the past three months. But still, the economists warn that a recovery of the housing market will be “long and slow.”

A recovery of the real estate market is a necessary condition to prevent further drops in household wealth and continued financial risks related to mortgage financing and default activity, the economists noted.

“Unfortunately, the data on the housing front has not swayed us strongly in either direction. While we believe there has been some improvement over the last 3 months, it has not been enough to prompt a more optimistic economic outlook,” said Drummond.

If the ambiguity around the U.S. housing market lifts over the next quarter, there is potential to revise the outlook up for 2010, Drummond said.

IE