Gold rose above $1,600 for the first time in more than two weeks on Monday as a radical bailout package for Cyprus threatened to trigger fresh turmoil in the euro zone, driving investors to seek safety in gold.
But a firm dollar and general perception of an economic recovery quickly snuffed out the rally, sending gold below the key resistance level of $1,600.
The euro zone agreed on Saturday to hand Cyprus a bailout worth 10 billion euros ($13 billion), but forced the country's depositors to pay up to 10 percent on their savings despite the risk of a wider run on savings.
Investors are worried the proposal, if ratified by the Cypriot parliament on Monday, would become a dangerous template for future bailouts in the bloc and set off turmoil, after the market has grown more confident in the bloc's recovery in the past few months.
"The Cyprus crisis is bearish euro and bullish dollar, which is mathematically negative for gold," said Jeremy Friesen, commodity strategist at Societe Generale in Hong Kong.
"But it does raise the question how the ECB is going to continue to allow tightening of credit, which has been happening as a result of LTRO repayment."
The ECB pumped over a trillion euros into money markets in two long-term refinancing loans (LTROs), in December 2011 and February 2012, to provide liquidity for banks.
Friesen said if the ECB could turn on the tap again and help its economy by pumping more cash into the system, that would help gold, which thrives on ultra-loose monetary policies.
Spot gold rose to a 2-1/2-week high of $1,608.30 an ounce earlier in the day, before easing to $1,596.76 by 0319 GMT, up 0.3 percent from the previous close.
US gold also hit a 2-1/2-week high, at $1,607.6 an ounce, before paring gains to trade at $1,595.90.
Technical analysis suggested that spot gold faces resistance at $1,611 an ounce and may retrace to $1,586, Reuters market analyst Wang Tao said.
Investors will closely watch a US Federal Reserve policy meeting on Tuesday and Wednesday to assess the central bank's attitude towards aggressive monetary stimulus. Economists expected the Fed to keep buying bonds for the rest of the year to aid the still frail economic recovery.
Interest in exchange-traded gold funds remained lukewarm on Friday. Holdings of SPDR Gold Trust, the world's biggest gold ETF, resumed the decline after a two-day pause, down 3.311 tonnes to 1,232.996 tonnes, the lowest since October 2011.
Speculators raised net long positions in U.S. gold by 9 percent in the week to March 12 from a more than five-year low of 39,631 contracts to 43,195 contracts, data from US Commodity Futures Trading Commission showed.
But speculators' short positions in gold continued to increase, up nearly 2 percent from a week earlier to 70,126 contracts, the highest since at least 2006.
"There is a chance that gold was oversold and reflected too hawkish a view on policy and too optimistic a few on growth in the near term," said Friesen.
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