Expectations of low U.S. interest rates and one-way bets against the dollar saw it emerge as the new funding currency of choice for FX carry trades, the Bank for International Settlements (BIS) said in its quarterly review.

Under carry trades, investors borrow in a currency with low interest rates to invest in high-yielding and growth-linked ones or riskier assets like stocks and commodities which generate higher returns.

Traditionally the yen and the Swiss franc have been used to fund these leveraged trades, but expectations that the U.S. Federal Reserve will keep rates near zero and resort to quantitative easing led to the dollar emerging as the markets' preferred choice between August and early November this year.

Appreciation pressures were stronger for countries with high growth prospects and larger interest rate differentials, the BIS said.

Appreciation was generally smaller for the currencies of countries that continued to manage their exchange rate fully or partially against the U.S. dollar. As a result, appreciation was less pronounced in Asia, and China in particular.

The BIS said the acceleration of capital inflows was reflected in higher stock prices in a number of emerging market countries and also visible in bond prices.

On the other hand, the dollar index <.DXY>, a measure of the greenback's performance against a basket of currencies, lost more than 17 percent between early June and November 4 this year as hedge funds, central banks and others sold the dollar.

It has since rebounded as investors set aside concerns about a slowdown in the U.S. to focus on sovereign debt problems in the euro zone.

The BIS said foreign exchange carry trade volumes are difficult to track due to a lack of data. It also partly reflects the fact that these trades are often undertaken through derivatives instruments such as cross-currency positions in futures, forwards and swaps.

However, the Chicago currency futures market does offer some insight, especially about whether speculators like hedge funds and other non-bank financial institutions are going long or short on a currency.

Data from the Commodity Futures Trading Commission show that speculators had extended short dollar positions ahead of the Fed's decision to implement the second phase of quantitative easing in early November.

Those positions have since been trimmed, but speculators are still long on the Australian dollar, Canadian dollar the New Zealand dollar and the Mexican peso, all considered high-yielding currencies.

The Australian dollar has been a clear outperformer, having gained nearly 10 percent against the U.S. dollar and riding past parity earlier this year. Australian interest rates at 4.75 percent are amongst the highest in the developed world, making it an attractive investment for carry trades.

The BIS said risk reversals--or the premium required to hold a put or a call option in a currency -- reflected a view that the dollar would weaken against most major currencies during the August to November period.

Rising net long positions in the yen and the Swiss franc, which have historically been the preferred carry trade funding currencies, were also consistent with expectations of U.S. dollar weakening, the BIS said.

(Editing by Toby Chopra)

China Quantitative easing