(Updates with comment, prices)
* Gold rallies with crude after EU agreement
* Set for largest two-day rally since October
* Fed forecasts could support gold in future
LONDON, Jan 4 (Reuters) - Gold was set for its strongest two-day rally in 2-1/2 months on Wednesday after an agreement in principle among European leaders to ban Iranian oil imports boosted the crude price and catapulted bullion to two-week highs.
European Union governments reached a preliminary agreement to ban imports of Iranian crude but have yet to decide when such an embargo would be put in place, EU diplomats said on Wednesday.
Brent crude futures rose by more than $1 a barrel above $113 in response to the news, prompting a sharp bounce in the gold price, which can often rise in response to geopolitical uncertainty.
Spot gold was last up 0.4 percent on the day at $1,607.89 an ounce by 1527 GMT, having risen by as much as 0.7 percent to a session high of $1,614.10, while most-active COMEX February gold futures were up 0.6 percent at $1,609.30.
"The market is tense. It is the beginning of the year, there isn't any major positioning as such in the market and everyone is trying to figure out, heads or tails, whether or not to go in and any sort of news like that triggers buying," said Afshin Nabavi, head of trading at MKS Finance.
"People are itching to buy but don't know whether to buy here ... we have non-farm payrolls coming out on Friday, so ahead of that, a lot of people are going to be cautious," he said.
The decline in the gold price towards the end of 2011 appears to have lured some buyers out of the woodwork following a fairly lacklustre previous few weeks, due in large part to the weakness in the Indian rupee against the dollar, which suppressed demand in the world's largest consumer of gold.
Friday's monthy non-farm payrolls report is expected to show 150,000 jobs were added in December, following November's 120,000 increase.
The Shanghai Gold Exchange registered record-high trading volumes on Wednesday, and local dealers in Singapore said they expected demand to pick up next week ahead of the Chinese New Year.
"Our physical sales to India yesterday were about double average levels," wrote UBS analyst Edel Tully. "The key factor in this market right now is not purely the gold price, but stabilisation in the rupee. China returned to the market today, and based on turnover on the SGE they're liking gold."
The dollar hit one-week highs against the Swiss franc and session highs against the euro, while Treasury prices fell to intraday lows.
The Federal Reserve's decision on Tuesday to publish the longer-term forecasts of its policymakers could push back expectations of when U.S. benchmark rates will rise, creating a potential future boost for gold.
Gold tends to benefit from an environment of low interest rates because the opportunity cost of holding it - the premium investors forfeit by not holding yield or dividend-bearing stocks or bonds - declines.
In the Middle East, tension has increased between Iran and the West over the country's nuclear programme, which Washington and its allies say is a cover to build bombs.
Iran has been hit by foreign sanctions, including four rounds of U.N. sanctions over its refusal to halt its sensitive nuclear work as demanded by the U.N. Security Council.
Iran threatened this week to choke off crude shipments through the strategic Strait of Hormuz in retaliation against tougher sanctions from the West over its nuclear programme.
"With 40 percent of the world's internationally traded oil moving through the Strait of Hormuz, even a low probability of the strait's closure - Iran threatened to do this last month if it were subject to further sanctions - can have a material impact on oil and hence on gold prices," James Steel, analyst at HSBC, said.
Silver fell by 1.2 percent on the day to $29.29 an ounce, pushing the number of ounces of the metal needed to buy an ounce of gold up for the first time since Friday.
The gold/silver ratio is now at 54.91, having fallen from last December's 14-month high of 57.4, when gold's outperformance against silver reached its strongest since October 2010.
Platinum was last down 0.1 percent at $1,422.99 an ounce, while palladium eased 0.8 percent to $653.97 an ounce.
Over the last month, palladium has easily outperformed the other three major precious metals, having risen by nearly 2.5 percent, compared with price losses in gold, silver and platinum in this time. (Editing by Anthony Barker)