* Canadian dollar strengthens with stocks, oil
* Drop vs US$ in 2008 is worst fall in decades
* Bond prices slip in light activity
By Lynne Olver
TORONTO, Dec 31 (Reuters) - The Canadian dollar inched higher against the U.S. currency on Wednesday afternoon in subdued pre-holiday trading as thinly staffed desks processed minimal orders and shifted their focus to 2009.
For the full year, the Canadian dollar posted its worst annual drop in more than 50 years, after an unusually strong 2007 performance against the greenback, as plunging commodity prices in the second half of 2008 took their toll.
Government bond prices closed lower after solid gains in 2008 as investors around the world shunned risk. The bond market shut early ahead of the New Year's Day holiday.
At 2:25 p.m. (1925 GMT) the Canadian currency had strengthened to C$1.2170, or 82.16 U.S. cents, after a swift afternoon increase in crude oil prices lifted Canadian stocks.
That was higher than Tuesday's close of C$1.2210 to the U.S. dollar, or 81.90 U.S. cents.
"Flows have been very light and moves are exaggerated. Anything could happen in the next two hours but I think most market participants on the corporate side have started vacating their offices," said Dave Bradley, director of foreign exchange trading at Scotia Capital in Toronto.
For the year, the Canadian dollar has slumped 18.7 percent, its worst annual showing against the U.S. dollar since at least 1950, although it did rise against other currencies.
Traders and strategists said that corporate flows drove most activity this week.
"In essence, we're just executing business that has to be done before the month-end," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.
Several analysts said further weakness is probably in store for the currency in 2009's first quarter, given that a global recession should hurt demand and prices for commodities. These swings tend to affect the Canadian dollar due to the country's hefty energy and materials exports.
But Osborne said he anticipates a broad-based decline in the U.S. dollar next year. In his view, U.S. short-term interest rates near zero, the recession, a U.S. budget deficit and non-conventional monetary policy will weigh on the greenback, possibly lifting the Canadian currency to C$1.15 to the U.S. dollar by year-end.
The Canadian dollar was worth slightly more than its U.S. counterpart at the start of 2008, after jumping 17.4 percent in 2007. But in the second half of 2008, credit markets worsened, U.S. financial companies melted down, a global recession loomed and commodity prices fell, taking the shine off the currency.
Although it lost ground against the U.S. dollar and other majors in 2008, it outperformed sterling, the Australian and New Zealand currencies, Osborne noted.
Several events in January could influence the market, including the Bank of Canada's interest rate decision on Jan. 20 and a federal budget on Jan. 27 that should contain an economic stimulus package.
BONDS END LOWER
Domestic bond prices slipped in light trade, in tandem with the U.S. Treasury market, capping a strong year for government-issued bonds.
"It has been a theme of flight to quality and flight away from distressed assets," said Levente Mady, a broker at MF Global in Vancouver, British Columbia, who specializes in fixed-income investments.
"The weaker the credit, the worse beating it took" in 2008, he added.
But because price gains have pushed government bond yields lower and lower, Mady said his firm recommends that clients move out of government bonds into higher-yielding products such as provincial bonds and select blue-chip corporate bonds.
The two-year Canada bond closed down 4 Canadian cents at C$103.10 to yield 1.100 percent. The 10-year bond eased 25 Canadian cents to C$112.90, yielding 2.688 percent.
The yield spread between the two-year and 10-year bond was 159 basis points, versus 158 at the previous close.
The 30-year bond was down 95 Canadian cents at C$127.70 and its yield was 3.460 percent. In the United States, the 30-year treasury yielded 2.695 percent. (Reporting by Lynne Olver; editing by Rob Wilson)