By Cameron French

TORONTO (Reuters) - For Canada's banks, anincreasingly gloomy economic picture combined with regulatoryuncertainty may soon sap the momentum they managed to sustainthrough their latest quarter.

The banks reported a decline in capital-market tradingincome for their recently completed financial third quarterthat wasn't worse than expected, which spurred investors tobreathe a collective sigh of relief.

But, overall, Canada's "Big Six" reported a decidedly mixedperformance. Two banks topped analysts' estimates, two missed,and two were roughly in line.

Even so, the Toronto Stock Exchange's financials sector rose 4.2 percent over the past two weeks as theresults trickled in, outperforming the 3.6 percent rise of themarket's main index.

Observers say things won't soon get much better than thisas growth in core retail banking starts to stall. Business andpersonal loans, particularly mortgages, are expected to flagalong with an expected slowdown in economic growth.

"I think, going forward, the issue becomes: Do you getsome kind of bounce back in capital markets, and, if so, isthat going to be offset by weaker trends in the Canadianhousing market?" said Sumit Malhotra, an analyst at MacquarieEquities Research.

Canada's housing market suffered a much more mild slowdownthan the U.S. market, and its quick rebound helped bank profitsrecover quickly from the financial crisis.

But, even though Canadian interest rates remain low,housing sales have begun to cool, prompting Toronto-DominionBank , which closed out bank earnings Thursday, towarn that rapid growth in retail bank revenue could soon end.

TD, one of three Canadian banks active in the United States-- Royal Bank of Canada and Bank of Montreal are the others -- faces additional headwinds from the evengloomier economic growth picture south of the border.

"Those were pretty good numbers (during the quarter), butthe warning sign is that in the U.S. you're not seeing anythinglike a healthier economy, you're not seeing consumer spendinggrowth," said Gavin Graham, president of Graham InvestmentStrategy in Toronto.

FULLY VALUED

With uncertainty surrounding the housing market, valuationssuggest bank stocks may have trouble making gains unlessanother catalyst emerges, analysts say.

"When you look at where they're trading on a relative tohistorical basis and on a forward price-to-earnings basis,they're actually reasonably valued," said Barclays Capitalanalyst John Aiken.

Current price-to-earnings ratios for the banks, based onnext year's expected earnings, are in the 10-13 range, whichanalysts say is normal for the sector.

Aiken notes the Canadian banks are trading at much higherrelative valuations than their U.S. counterparts, which haveyet to fully rebound from the financial crisis.

"If you're looking at an economic recovery scenario,particularly in the U.S., the Canadian banks don't have thatmuch multiple expansion left in them. ... So anyone who'soptimistic on the (economic outlook) is kicking the tires onU.S. and European banks, not Canadian banks," he said.

DIVIDENDS ON HOLD, FOR NOW

A resumption in dividend hikes could spur share prices, butbanks are waiting to act on dividends until the Basel globalbanking committee comes up with tighter capital and liquidityrules, which will be aimed at avoiding a repeat of thefinancial crisis.

While the banks will likely get the green light to raisepayouts when the Basel rules are released in November, only oneor two lenders are expected to respond immediately with hikes.

Analysts expect the banks to try to maintain dividendpayout ratios -- the percentage of profits committed to pay thedividend -- in the 40 to 50 percent range, meaning banks thatare at the high end of that range would likely wait untilprofit increases before they would hike the payout.

National Bank of Canada, Canada's No. 6 bank,currently has a ratio around 40 percent and the bank's chiefexecutive, Louis Vachon, said last week that National would be"a lot more precise about our capital plans" when it holds itsnext quarterly conference call, a statement some took to mean adividend hike is coming.

TD, which has a payout ratio around 47 percent, is expectedto raise its dividend early next year.

The remaining Big Six, whose ratios are around or above 50percent, will likely wait a few more quarters, which woulddelay the valuation bump that would come with the move.

"I think that near term, some of the chatter surroundingdividends could give the banks some support. But in our mindthat needs to be joined by a re-acceleration in revenue growthto significantly get the stocks moving," Malhotra said.

($1=$1.04 Canadian) (Reporting by Cameron French; editing by Peter Galloway)