By Karen Brettell

NEW YORK (Reuters) - The U.S. dollar hit a two-year high and was on track to post an annual gain against almost all major currencies on Tuesday as the prospect that the Federal Reserve will hold interest rates higher than peers led the U.S. currency to dominate rivals.

Traders have adjusted for the U.S. central bank to take a slow and cautious approach to further rate cuts next year as inflation remains above the Fed’s 2% annual target.

Analysts also expect policies to be introduced by president-elect Donald Trump, including business deregulation, tax cuts, tariffs and a clampdown on illegal immigration, to boost growth and add to price pressures next year.

That has sent yields on U.S. Treasuries higher and the bolstered demand for the U.S. currency.

"Yields in the U.S. have adjusted higher to price in the potential inflationary impact from the incoming Trump administration’s policy agenda including tariff hikes, tighter immigration policy and maintaining loose fiscal policy," said Lee Hardman, senior currency analyst at MUFG.

The dollar index <=USD> was last up 0.41% on the day at 108.49 and earlier reached 108.58, the highest since Nov. 2022. It is headed for an annual gain of 7.0%.

Weaker growth outlooks outside of the United States and rising geopolitical tensions in the middle east and the ongoing Russia/Ukraine war have added to demand for the U.S. currency this year.

The greenback has been boosted by "rising growth concerns elsewhere against the background of geopolitical risk," analysts at Action Economics said in a note.

Trading volumes were thin on Tuesday before the New Year holiday on Wednesday.

The Japanese currency was among the biggest losers of the year and was on pace for its fourth yearly loss against the greenback as it suffers from a wide interest rate differential between Japan and the United States.

Analysts expect the Japanese currency to eventually be supported by further Fed easing and interest rate increases by the Bank of Japan. Until then traders are on watch for intervention by Japanese authorities, after they stepped in to support the currency several times this year.

The greenback was last up 0.29% at 157.28 yen and on track for a 11.5% yearly gain.

The euro fell 0.52% to $1.0353 and is on pace for a 6.2% yearly decline, with traders expecting the European Central Bank to be sharper with its cuts than the Fed.

Sterling weakened 0.34% to $1.2508 and was on course for a 1.6% fall in 2024, the strongest performance of any major currency against the dollar this year.

The Australian and New Zealand dollars both fell to two-year lows on Tuesday. The Aussie was set for a drop of around 9.2% this year, its weakest yearly performance since 2018. AUD/

The kiwi was poised for a 11.4% decline, its softest performance since 2015.

In cryptocurrencies, bitcoin gained 2.07% to $93,824. It reached a record high of $108,379.28 on Dec. 17 and is set for a 121% gain this year.

(Reporting by Karen Brettell; Additional reporting by Ankur Banerjee and Harry Robertson; Editing by Louise Heavens and Nick Zieminski)