Gold was set for its biggest daily gain in over a week on Tuesday, after a downgrade to Italy's credit rating added to the strain on European leaders to solve the region's debt crisis.

In the latest blow to the euro zone, S&P cut Italy's sovereign credit rating by one notch, saying its economic growth prospects were getting weaker and planned reforms by the government would not help much.

A measure of German analyst and investor sentiment fell to its lowest in nearly three years last month, while Greece raced to make more cuts to its vast public sector to convince its international creditors that it can meet its loan conditions.

Gold shrugged off a rise in European stocks, which would normally reflect a pick-up in investor appetite for risk. But the rise on the stock market was led mostly by so-called defensive shares, which act almost as safe-havens.

Spot gold was last up by 1.5 percent at $1,806.40 an ounce by 1443 GMT, having fallen by nearly 1 percent so far this week, in its third consecutive weekly decline, although analysts said the market was unlikely to fall much further in the current environment of high uncertainty.

Basically a lot of the supportive factors for gold are still in place, so although we saw a bout of dollar strength (earlier) that took the whole commodities complex lower, things like Asian demand are very strong at this point, said Standard Chartered analyst Daniel Smith.

Gold is rallying ... partly on the European situation, but also because there is this underlying uptrend in demand.

The volatility in gold prices in the past few weeks has deterred some gold investors, as evidenced by the decline in speculative holdings of U.S. gold futures <0#CFTC:> and a fall of nearly 2 million ounces in holdings of the metal in exchange-traded funds over the last month.

 

NERVES FRAY

Bank of China , a big market-maker in China's onshore foreign exchange market, has stopped foreign exchange forwards and swaps trading with several European banks due to the unfolding debt crisis in Europe, causing some distress in market sentiment.

Increasingly over the last couple of weeks, we've seen stories about how safe something is that is as volatile and that is doing a bit of damage here and has caused a few people to pull out and go on the sidelines, said Saxo Bank senior manager Ole Hansen.

The $1,765/70 area is reasonable support and that is giving a bit of confidence back to the buyers. But we really have been in a downtrend for the best part of the last couple of weeks and that needs to be broken ... and for that, we need to move back above back above $1,825, he said.

But uncertainty surrounding the outcome of the U.S. Federal Reserve's next policy meeting should whet short-term appetite for the metal, while in the longer-term, robust demand from fast-growing emerging economies was expected to continue.

Gold demand in China, the world's largest gold producer and second-biggest consumer, could rise 10 percent this year as consumers choose the metal as a form of wealth protection, the World Gold Council said on Monday.

Gold is likely to hold steady over the coming day or so as investors await the outcome of the Fed's two-day policy meeting, at which the central bank is widely expected to signal what action it will take to encourage economic growth.

While markets are discounting a return to government bond purchases, the Fed has more tools at its disposal to boost consumer spending by keeping interest rates low, which create a supportive environment for gold, which carries no yield of its own and loses out to other dividend- or yield-bearing assets when rates rise.

Spot silver rose 1.5 percent to $40.07, but off the three-week low of $38.95 hit in the previous session.

Platinum rose by 0.4 percent to trade at $1,778.50 an ounce, while palladium rose 0.2 percent to $714.97.