Gold bull run set for breather as rate hikes eyed

LONDON (Reuters) - Gold's decade-long bull run may plateau in the medium term as a rise in U.S. interest rates from record lows makes prices vulnerable to a dollar recovery and weaker investment demand.

While fears over the stability of paper currencies and inflation may keep gold high, it will struggle to maintain the soaring investment flows that took it to an all-time peak of $1,226.10 an ounce in December, analysts say.

In the short term, gold's underlying fundamentals look fragile as jewelry demand languishes and miners lift supply. Spot prices had retreated from their December highs to around $1,076.50 an ounce by early afternoon on Wednesday.

"We see a number of headwinds for investors in gold, most notably potential increases in rates," said RBS Global Banking & Markets analyst Daniel Major. "The opportunity cost of investing in commodities is going to be important."

"RBS currency strategists are forecasting further strength in the dollar against the euro and potential rate hikes in the second half of next year," he added. "Both of those are potentially negative factors for gold investment."

Gold's bull run since early 2001 has gone hand-in-hand with dollar weakness, but the U.S. unit has firmed since December as fears over rising euro zone debt levels knocked the euro.

But moves in U.S. interest rates from current record lows will be the main driver of the dollar, and consequently gold.

A Reuters poll released earlier this week showed primary dealers believe the U.S. Federal Reserve will start lifting rates in the fourth quarter of 2010.

While gold may be able to shrug off a rebound in the dollar if other factors emerge, analysts are skeptical it will make significant new gains in such an environment.

"You can be a gold bull and still believe in rising interest rates if you believe in inflation, which a lot of gold bulls do," said Daniel Sacks, a portfolio manager at Investec Asset Management. "We're not convinced."

"You can see the point that a huge increase in money supply, you'd think, would cross over into inflation, but it is not clear whether that mechanism will hold or not."

DEMAND UNCERTAIN, SUPPLY SEEN RISING

Gold's gains have also been boosted by limits on official sector sales and, more recently, central bank buying.

India bought 200 tonnes of gold late in 2009, and news of heavy Chinese buying broke earlier in the year. But analysts say more central bank buying is unlikely at elevated prices levels.

Gold miners' buy-backs of forward sales are also unlikely to remain a significant source of demand as only one large miner, AngloGold Ashanti, still holds significant hedge positions.

Miners are responding to rising prices by upping production.

In December the world's biggest miner Barrick Gold, said its output should continue to trend higher past 2010, while number two gold miner Newmont Mining said it sees output climbing 5-10 percent this year.

"High prices have massively incentivized additional exploration, and there are a lot of new gold mines coming on stream," said Natixis analyst Nic Brown. "We see supply increasingly substantially in the immediate years ahead."

Jewelry consumption, which typically makes up two-thirds of global demand, fell 23 percent last year as high prices put off buyers, data from the World Gold Council showed.

While this was outweighed by a sharp rise in investment demand, a retreat in holdings of gold-backed exchange-traded funds in the early weeks of the year is worrying analysts.

There is however a significant upside risk to prices. Further worries over broad-based currency devaluation based on lingering instability in the financial markets could see interest in gold rise as an alternative store of value.

"Every currency in the western world is being devalued," said Eddington Asset Management's chief investment officer Alex Allen. "Therefore gold has some kind of value to investors."

For graphic showing a selection of banks' medium-term price forecasts, click on: here

(Additional reporting by Veronica Brown; Editing by Sue Thomas)