The strategy lost 2.5 percent in 2010 as the dollar — a favorite for financing the trades because of record low U.S. rates — appreciated, according to an index compiled by UBS AG, the world’s second-largest foreign-exchange trader. That’s more than the 0.98 percent drop in 2008 when the collapse of Lehman Brothers Holdings Inc. caused credit markets to freeze and the worst performance for so-called carry trades since at least 1999 when UBS began releasing yearly figures.

Falling demand for carry trades may help the greenback extend a rally that drove IntercontinentalExchange Inc.’s U.S. Dollar Index up 4.5 percent from its 12-month low on Nov. 4. Gains in manufacturing and retail sales are leading investors to buy the dollar, rather than sell it to fund other investments.

“The U.S. will look reasonably better compared to other economies,” said Mitul Kotecha, Hong Kong-based head of global foreign-exchange strategy at Credit Agricole CIB, a unit of France’s second-biggest bank. “Bond yields will move higher, and that will certainly reduce substantially the attraction of the dollar as a funding currency.”

Futures traders cut bearish bets against the dollar last quarter by the most in a year, figures from the Commodity Futures Trading Commission in Washington showed.

Less Bearish

The difference in the number of wagers by large speculators on a decline in the currency compared with those on an advance — so-called net shorts — was 167,031 on Dec. 21, down 32 percent from 245,789 on Sept. 30. It was the biggest drop since a 49 percent decrease in the final quarter of 2009. The Dollar Index rallied 10.5 percent in the following six months.

The Dollar Index, which tracks the U.S. currency against the euro, yen, Swiss franc, Canadian dollar, British pound and Swedish krona, rose to 79.028 at the end of last week from the November low of 75.631. Over that period, the greenback advanced the most against the euro and the Danish krone of its 16 most widely traded counterparts. The index climbed 0.2 percent to 79.316 as of 7:16 a.m. in London today.

Strength in the dollar has run counter to predictions by officials in Japan, Germany and China who said the Federal Reserve’s plan to spark the economy by purchasing $600 billion of Treasurys through June would weaken the greenback.

‘Weak-Dollar Policy’

Japanese Prime Minister Naoto Kan said on Nov. 4 the U.S. was following a “weak-dollar policy” through its plan to buy Treasuries. Chinese central bank adviser Xia Bin said the Fed’s quantitative easing amounted to “uncontrolled” money printing. German Finance Minister Wolfgang Schaeuble called the strategy “clueless.”

Instead the dollar advanced as economists boosted their growth estimates and President Barack Obama extended tax cuts to spur growth in 2011. Industrial production rose 0.4 percent in November, the most in four months, according to Fed data. Sales at U.S. retailers advanced 5.5 percent during the holiday season, the best performance in five years, according to MasterCard Advisors’ SpendingPulse.

Pacific Investment Management Co., which runs the world’s biggest bond fund, raised its 2011 forecast for the U.S. economy to a range of 3 percent to 3.5 percent, versus its previous estimate of 2 percent to 2.5 percent, the Newport Beach, California-based firm said in a report Dec. 23.

Lagging Behind

The euro economy, which added Estonia as its 17th member on Jan. 1, will expand 1.5 percent and Japan’s will grow 1.3 percent, according to median forecasts of analysts surveyed by Bloomberg.

“We’ve started to go back to more of an old school way to looking at the dollar in terms of economic releases,” said Fabian Eliasson, head of U.S. currency sales at Mizuho Financial Group Inc. in New York, part of Japan’s second-largest bank. “The recovery should be steady and should improve relatively better than the rest of the world, which is positive for the dollar.”

While a stronger currency may restrain profit growth at companies with international sales, it’s important to the U.S. because it entices foreign investors to buy the debt that finances the nation’s $1.3 trillion budget deficit.

Treasury yields indicate investors added to bets in November and December that U.S. borrowing costs would rise. Two- year rates climbed to 0.75 percent on Dec. 28, the most since June, from a record low 0.31 percent in November. Ten-year yields jumped to as much as 2.35 percentage points more than similar maturity Japanese debt on Dec. 28, the most since May 3.

‘Biggest Driver’

Rising Treasury yields have been “the biggest driver” of dollar strength in the past month, said Geoff Kendrick, head of European foreign-exchange strategy at Nomura International Plc in London, a unit of Japan’s biggest brokerage. “With yields so high in the U.S., at some point you want to switch out of dollar funding and into yen funding.”

The greenback became a financing currency after the Fed cut its target rate for overnight lending between banks to a range of zero to 0.25 percent in December 2008, from 1 percent. By contrast, South Africa’s rate is 5.50 percent, while the Reserve Bank of Australia has lifted its benchmark seven times since October 2009, to 4.75 percent.

The most profitable carry trade in 2010 was borrowing in the U.S. and investing in Australia, which returned 19.1 percent, according to data compiled by Bloomberg. The South African rand was next with an 18.7 percent return, followed by 14.5 percent for the Japanese yen.

UBS’s V24 Carry Index gained 13.9 percent in 2009.

‘Quite Bullish’

The carry trade remains attractive to Mitsubishi UFJ Asset Management Co., a unit of Japan’s biggest bank. The Fed may need to arrange another round of quantitative easing to sustain the expansion, increasing the supply of dollars and debasing the currency, said Hideo Shimomura, who as the company’s chief investor helps oversee the equivalent of $59.8 billion in Tokyo.

“We are quite bullish on high-yield countries,” Shimomura said. “The U.S. expansion is not a done deal.”

Mitsubishi UFJ Asset added to its holdings of Australian dollars a few months ago and bought Canadian dollars in December, Shimomura said. Canada’s central bank rate of 1 percent compares with what the Bank of Japan calls its “virtually” zero level.

Australia’s dollar climbed 1.9 percent last week to the highest level since July 1982, and Canada’s dollar strengthened 1 percent, exceeding parity with its U.S. counterpart for the first time since November.

Kei Katayama, leader of the foreign fixed-income group at Daiwa SB Investments Ltd. in Tokyo, spent 2010 seeking higher yields than those available in Japan by investing in Australian dollars, Norwegian krone, Canadian dollars and Swedish krona.

‘Getting Rich’

Now those currencies already reflect the prospects for economic growth in their home nations, he said.

“I’m not that bullish compared to six months ago,” said Katayama, who helps oversee the equivalent of $54.3 billion. “Those currencies are getting rich.”

Daiwa SB, a unit of Japan’s second-biggest brokerage, trimmed holdings of Norwegian krone and Canadian dollars in the third quarter, Katayama said. He put the money mostly in dollars and also in euros.

Last year, investors who had borrowed dollars to buy the Danish krone and the euro lost 6.4 percent and 6.2 percent respectively, according to data compiled by Bloomberg.

Inflation-adjusted yields on benchmark 10-year Treasurys are 2.20 percent, near the most in a year, which may help the U.S. lure investors. The figure is higher than 1.26 percent for Germany, 1.03 percent in Japan and 0.10 percent in the U.K.

“There used to be consensus that the dollar will weaken,” said Daisaku Ueno, Tokyo-based president of Gaitame.com Research Institute Ltd., a unit of Japan’s largest online currency broker. “But now maybe there isn’t. The dollar-carry trade faces the risk of unwinding.”