By Scott Murdoch

SYDNEY, Feb 20 (Reuters) - One of Australia's largest pension funds, UniSuper, has increased hedging of its overseas investments as it says the local currency is undervalued and will rise as the interest rate differential between Australia and the U.S. widens.

The Aussie dollar was trading at $0.7056 on Friday, down from this month's three-year top of $0.71465 but well up from the low of $0.6422 in November, when the currency started its climb.

The Aussie's strength has prompted a number of Australian pension funds, known locally as superannuation funds, to increase their hedging of international investments to reduce exposure to the U.S. dollar.

John Pearce, the chief investment officer of UniSuper, which has A$166 billion ($116.8 billion) in funds under management, said the fund had "tweaked" its hedging strategy lately as it believes the local currency should be trading higher.

"I've been surprised that it's taken the Aussie so long to get to 70 cents to be honest," Pearce told Reuters in an interview.

"Commodity prices are pretty strong. Usually when your terms of trade are strong, the Aussie would trade higher than it is," he said.

"It's really been the interest rate differential that's been keeping it lower. And now that's getting in the Aussie's favour, I think you're going to see upward pressure."

The Aussie strengthened more than 1% earlier this month when the Reserve Bank of Australia raised the cash rate by a quarter point to 3.85%. Financial markets predict at least one more hike this year.

Meanwhile, the U.S. Federal Reserve held its benchmark rate steady in January in the 3.50%-3.75% range. Traders price in roughly two rate cuts this year, according to the CME Group's FedWatch Tool.

Australian pension funds invested in U.S. equities would typically have very little currency hedging because the U.S. dollar tends to act as a safe haven, appreciating when there are negative shocks.

"We're actually now getting paid to hedge," Pearce said. "When Aussie rates were below U.S. rates, it was costing money. Now there's a carry, that's one positive."

Australian Retirement Trust (ART), the country's second-largest pension fund, and HESTA have both increased hedging of overseas investments in recent months, Reuters reported.

Pearce downplayed worries that Australian pension funds holding more Aussie dollars could place undue upward pressure on the currency.

"I just don't see a world where that's going to be a problem," he said, because the currency market "is just so big."

($1 = 1.4215 Australian dollars)

(Reporting by Scott Murdoch; Editing by Kevin Buckland)