Gold dives 4 percent on fund liquidation, technicals

Gold and silver bars are pictured at the Austrian Gold and Silver Separating Plant 'Oegussa' in Vienna August 26, 2011.

NEW YORK (Reuters) - Gold dropped 4 percent on Wednesday as a technical sell-off, year-end fund liquidation and plunging commodities fueled bullion's second-biggest decline since the 2008 economic crisis.

Bullion fell below $1,600 an ounce for the first time since early October. Losses snowballed after it broke below its 200-day moving average -- a technical support it had held for nearly three years. Gold option volatility also exploded as futures investors sought to hedge against downside risk.

The magnitude of gold's decline dwarfed equities' losses and some traders said the selling appeared to lead the rout across commodities. Oil and copper also fell 5 percent on the day.

Bullion was already pressured by the previous session's news the U.S. Federal Reserve did not offer new economic stimulus.

That momentum increased on Wednesday as the euro dropped below $1.30 and a shortage of dollar funding prompted investors to sell aggressively.

Banks' dollar borrowing from the European Central Bank tripled on Wednesday compared to the prior week as the euro zone debt crisis has caused money markets to seize up.

Rampant market talk that possible liquidation by a big hedge fund to meet redemption demand ahead of the year end also weighed heavily on bullion market sentiment.

"It appears that there is significant amount of forced selling. The way gold is falling it looks like a big fund is blowing up, prompting forced-redemption selling," said James Dailey, portfolio manager of the TEAM Financial Asset Management with $200 million in fund assets.

Spot gold fell 3.9 percent to $1,568 an ounce by 3:26 p.m. EST. It hit a session low of $1,563.99, its lowest since late September.

Silver tumbled 6.5 percent to $28.76 an ounce.

Bullion notched its biggest three-day slide since late September.

HSBC said that gold was hit by a push among investors to get more cash onto their balance sheet ahead of the year end.

"Some macro hedge funds are liquidating gold holdings and taking profits in a difficult year. As trading volume typically drops toward year-end, we expect increasingly volatile price swings," said James Steel, chief technical analyst at HSBC.

Gold has slid 18 percent since hitting $1,920 an ounce in September, a drop that takes it closer to bear market territory and might signal a peak in bullion's decade-long rally.

In September, gold prices tumbled sharply from a record partly on speculation of hedge fund sales.

At that time, there was talk hedge fund manager and long-time gold bull John Paulson might have liquidated his holdings to meet end-of-year client redemptions.

Paulson & Co. revealed in a U.S. regulatory filing two months later that it had cut its holding in the SPDR Gold Trust GLD by a third in the third quarter, a sale which was equivalent to 1.1 million ounces of gold.

U.S. gold futures for February delivery settled down $76.20 at $1,586.90 an ounce.

Trading volume was 50 percent above its 30-day moving average to be one of the busiest sessions in the last three months, bucking a recent trend of weaker turnover.

A commodity market maelstrom also prompted investors to sell gold to cover losses elsewhere, as U.S. crude oil futures sank about 6 percent and copper dived 5 percent. However, the S&P 500 U.S. stock index fell only about 1 percent.

Also weighing on gold is a physical market glut created by the excess supply of gold lending by European banks in return for U.S. dollars. Gold leases rates are at their lowest levels in more than 10 years, analysts said.

TECHNICAL BREAKDOWN BELOW 200 DMA

Spot gold broke below its 200-day moving average for the first time since January 2009 as some analysts said that a break below that defining parameter could spell the end of gold's three-year bull trend.

(Additional reporting by Amanda Cooper in London; editing by Andrea Evans, Bob Burgdorfer, Sofina Mirza-Reid, Josephine Mason and David Gregorio)