Dec. 17 (Bloomberg) -- The Australian dollar rose from a three-month low as some traders considered its drop too far as the economy expands and the central bank raises interest rates to an 11-year high.

The currency is headed for the biggest annual advance since 2003 as investors bet the Reserve Bank of Australia will increase rates next year, according to a Credit Suisse Group index based on trading in interest rate swaps. Australia's rate advantage over the U.S. is at a more-than-two-year high of 2.5 percentage points as the Federal Reserve cuts borrowing costs.

``The currency was a little bit oversold on Friday so it's rebounding,'' said Richard Grace, chief currency strategist at Commonwealth Bank of Australia in Sydney. ``The local economy is still strong.''

The Australian dollar climbed to 86.37 U.S. cents at 1:49 p.m. in Sydney after earlier reaching 85.96 cents, the lowest since Sept. 20. It was at 86.07 cents late in New York last week and may rise as high as 88.50 cents this week, Grace said. Australia's dollar gained to 97.78 yen from 97.50 yen late on Dec. 14.

The currency reached a 23-year high last month after the Reserve Bank of Australia raised the cost of borrowing to 6.75 percent. Australian two-year bonds yield 3.50 percentage points more than the equivalent U.S. Treasuries. The spread was 1.40 percentage points at the beginning of the year.

Traders' bets that a rate increase next year is a done deal ``is providing some support to the Australian dollar,'' said John Kyriakopoulos, a currency strategist at National Australia Bank Ltd. in Sydney.

Bets on Rate Rise

The Australian dollar is still the worst performer this month among the 17 most traded currencies, as the U.S. dollar has strengthened. Traders reduced bets the Federal Reserve will cut its benchmark from 4.25 percent on signs of inflation in the U.S. economy.

``The Australian dollar has broken lower decisively,'' said Peter Pontikis, treasury strategist at Suncorp-Metway Ltd. in Brisbane, Australia. ``There is returning confidence in the U.S. and a few people are going to have to reassess their Australian dollar targets.''

The currency may decline to 85 cents this week, the weakest since Sept. 19, Pontikis said.

Australian government bonds were little changed. The yield on the two-year benchmark rose 1 basis point to 6.80 percent. The price of the 7.5 percent bond maturing in September 2009 fell to 101.11 from 101.13. A basis point equals 0.01 percentage point.

To contact the reporter on this story: David McIntyre in Sydney at dmcintyre2@bloomberg.net

Last Updated: December 16, 2007 22:01 EST