By Jan Harvey
LONDON (Reuters) - Gold eased from three-week highs on Thursday as a recovery in the dollar prompted some buyers to cash in gains after the previous day's sharp rally, though the outlook for U.S. interest rates offered support.
The metal surged 1.5 percent on Wednesday after below-consensus U.S. payrolls data and dovish comments from Janet Yellen, chair of the U.S. Federal Reserve, dampened expectations of an imminent rate hike.
Gold is highly sensitive to rising interest rates, which lift the opportunity cost of holding non-yielding bullion while boosting the dollar, in which it is priced.
Spot gold reached its highest since May 18 in early trade, at $1,266.01 an ounce, before easing to $1,259.72 by 1319 GMT, down 0.2 percent. U.S. gold futures for June delivery were down 70 cents at $1,263.
"Gold is a bit lower as the dollar is doing (better), especially versus the euro," ABN Amro analyst Georgette Boele said. "We need to get the FOMC meeting behind us. I think afterwards markets will further price out the Fed, meaning gold and precious metals will go higher."
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The dollar, which on Wednesday slipped to a five-week low against a basket of currencies, regained some lost ground on Thursday, pressuring gold.
A grim mood on global financial markets sent investors searching for the security of the dollar and yen, driving both higher against a euro weakened by the prospect of prolonged low inflation and negative interest rates.
Investors have almost priced out the chance of a rate increase at the Fed Reserve's June 14-15 policy review and reduced the likelihood of a July increase to about 26 percent.
Yet markets remain cautious on Fed policy, analysts said.
"While there is likely further room to the upside for gold, there may be some road blocks to the rally near term," HSBC said in a note. "We expect that as the FOMC (Fed policy meeting) approaches, trading volume may quieten down and some near-term traders will book square and take profits."
"There is always the possibility the Fed surprises the market and raises rates, which could rapidly reverse gains."
Among other precious metals, silver hit a three-week high at $17.22 an ounce after climbing nearly 4 percent in the previous session, its biggest one-day gain since April 19.
The metal was later down 0.1 percent at $17.01. Platinum was 1.5 percent lower at $995.40, while palladium dropped 0.9 percent to $552.72.
(Additional reporting by Vijaykumar Vedala in Bengaluru; Editing by Mark Potter and David Goodman)