* Gold set for third straight weekly drop, biggest since March
* Fed outlook and dollar strength weigh on precious metals
* GRAPHIC-2016 asset returns: http://reut.rs/1WAiOSC (Updates throughout, changes dateline, pvs BENGALURU)
By Jan Harvey
LONDON, May 20 (Reuters) - Gold edged higher on Friday after two days of losses but remained on track for its biggest weekly slide in nearly two months on growing expectations of an increase in U.S. interest rates as soon as next month.
The dollar retreated from its highest in nearly two months against a currency basket but was heading for a third week of gains, keeping up pressure on gold. FRX/
Spot gold XAU= was up 0.2 percent at $1,256.70 an ounce at 0906 GMT, while U.S. gold futures GCv1 for June delivery gained $2.90 to $1,257.70. Spot prices are down 1.5 percent this week and facing a third straight week of losses.
"From the point of view that the dollar has strengthened it makes sense that precious metals pare back some of the recent gains," Saxo Bank analyst Ole Hansen said.
"We, however, managed to find support at $1,245, a key reversal level on gold. Negative yields and the prospect of higher inflation will continue to provide support."
New York Fed President William Dudley said on Thursday that there was a strong sense among central bank officials that markets were underestimating the probability of policy tightening. came a day after the minutes of the Fed's April meeting revealed that most policymakers felt a rate increase might be appropriate as early as next month. is highly sensitive to rising rates, which lift the opportunity cost of holding non-yielding bullion. The metal has rallied 18 percent this year as investors bet the Fed would hold off on further increases.
"The gold environment now is substantially different from what was apparent several weeks ago, when a weaker dollar and a benign rate environment were providing an element of support," INTL FCStone said in a report. "This is no longer the case."
Holdings of the world's largest gold-backed exchange-traded fund, SPDR Gold Shares GLD , rose by 4.5 tonnes on Thursday to their highest since November 2013. GOL/ETF
Gold demand in Asia was subdued this week by a strengthening dollar and weak seasonal demand in major trading centres. GOL/AS
In other precious metals, Silver XAG= rose 0.6 percent to $16.57, while platinum XPT= was up 0.9 percent at $1,016.49 and palladium XPD= gained 1.2 percent to $561.22.
Palladium was the biggest faller of the week, down 4.7 percent. A deepening deficit in the palladium market this year was predicted by industry experts gathered for Platinum Week in London. L5N18D1UP
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