* Canadian dollar edges higher vs U.S. dollar
* C$ to post worst annual drop in decades
* Bond prices tick lower
By Lynne Olver
TORONTO, Dec 31 (Reuters) - The Canadian dollar was slightly higher against the U.S. currency on Wednesday morning in subdued, pre-holiday trading, as thinly staffed desks were processing minimal orders and looking ahead to 2009.
The Canadian unit will post its worst annual drop this year in more than 50 years, after an unusually strong performance against the greenback in 2007, as plunging commodities prices in the second half of 2008 took their toll.
Bond prices were up modestly ahead of an early 1 p.m. ET market close before the New Year's Day holiday.
At 10:00 a.m. ET (1500 GMT), the currency was at C$1.2198 to the U.S. dollar, or 81.98 U.S. cents, up from Tuesday's close of C$1.2210 to the U.S. dollar, or 81.90 U.S. cents.
With limited liquidity this week, currency traders and strategists said corporate flows were driving activity.
"We're just swinging in the wind, it's very thin, there's some very modest month-end flows going through," said Shaun Osborne, chief currency strategist at TD Securities.
"In essence, we're just executing business that has to be done before the month end, there are not a lot of directional plays going on."
Overnight, the Canadian dollar held with a C$1.2160 to C$1.2190 range, then weakend early in the North American session to C$1.2275 before recovering ground.
Several analysts said they think the risk is skewed toward more weakness in the Canadian dollar in the first quarter of 2009, given that a global recession is expected to hurt demand and prices for commodities. This tends to hurt the Canadian dollar due to the country's significant energy and materials exports.
But Osborne said he anticipates a broad decline in the U.S. dollar next year, which could help the Canadian unit. In his view, nearly zero short-term U.S. interest rates, a recession, U.S. budget deficit and non-conventional monetary policy will weigh on the greenback, possibly pushing up the Canadian currency to C$1.15 by year-end.
At Tuesday's closing level, the Canadian dollar is down nearly 19 percent against its U.S. counterpart this year, its worst annual showing since at least 1950. The Canadian dollar began 2008 worth slightly more than its U.S. counterpart, after a 17.4 percent jump in 2007.
"It was a year of two halves for the Canadian dollar, it was generally quite stable in the first half and traded in a very narrow range against the U.S. dollar, really until mid-year we stuck close to parity," Osborne said.
But the Canadian dollar got "smacked around" in the second half, he said, when credit markets worsened, investors worldwide avoided risk, a recession loomed and commodities prices fell.
Although the Canadian dollar lost ground against the U.S. dollar, Japanese yen and Swiss franc in 2008, it outperformed sterling, the Australian and New Zealand currencies, Osborne noted.
"It was a bit of an average performance when taken in aggregate," Osborne said.
BONDS DOWN MODESTLY
Domestic bond prices were lower in light trade, in tandem with the U.S. Treasury market. The Investment Industry Association of Canada has recommended a 1 p.m. market close.
Yields on Canadian bonds continue to be higher than yields on comparable Treasury bonds, as the Canadian economy, while believed to be in recession, has not seen similar financial and real estate crises that emerged in the United States.
The two-year bond was down 7 Canadian cents at C$103.07 to yield 1.116 percent. The 10-year bond eased 35 Canadian cents to C$112.80, yielding 2.699 percent.
The yield spread between the two-year and 10-year bond was 158 basis points, unchanged from the previous close.
The 30-year bond was down 45 Canadian cents to C$128.20 and its yield was 3.437 percent. In the United States, the 30-year treasury yielded 2.575 percent. (Reporting by Lynne Olver, Editing by Chizu Nomiyama)