LONDON (Reuters) - Gold prices rose more than 1 percent to their highest in three weeks on Friday after data showing U.S. payrolls fell for a second straight month, and by more than expected, knocked the dollar.

Spot gold rose as high as $1,208.65 an ounce, its strongest since July 16, and was at $1,207.10 an ounce at 1308 GMT (9:08 a.m. EDT), against $1,193.10 late in New York on Thursday. U.S. gold futures for December delivery rose $9.90 to $1,209.20.

The Labor Department said non-farm payrolls dropped 131,000 last month, roughly double the 65,000 fall expected. Private employment, considered a better gauge of labor market health, rose by a smaller than expected 71,000.

Ole Hansen, senior manager at Saxo Bank, said the data had proved "a bad report that could bring forward additional monetary expansion, which can be dollar negative and therefore supportive for gold."

"It will give investors additional excuses to re-enter gold after the sell-off was rejected ahead of the 100 day moving average," he added.

The dollar hit a three-month low against the euro in the wake of the data, and was down 0.6 percent against a basket of six currencies .DXY. On the wider markets, U.S. stock index futures fell sharply and European shares wilted. .N

Traditionally, gold and the dollar trade inversely, with weakness in the U.S. unit lifting gold's appeal as an alternative asset and making dollar-priced commodities cheaper for holders of other currencies.

That relationship broke down earlier this year as both gold and the dollar benefited from risk aversion, but appears to be being re-established.

"We saw that negative correlation shift to a positive correlation between the dollar and gold since January, up until the last few weeks," said RBS analyst Daniel Major.

"Gold is going to fall back more into its traditional relationship with the dollar," he said.

A Federal Reserve policy meeting next week is now in focus, as a spate of weak economic data has strengthened the argument the Fed may have to take further steps to boost the economy.

ON TRACK FOR GAINS

Gold is on track to post its first weekly gain in four weeks, and its biggest such rise since the week to June 20. In addition to dollar weakness, prices have benefited from China's decision to open up its gold trade.

China is a key player in a number of commodity markets, but although it is the biggest producer and the second biggest consumer of gold, its trade has typically been largely domestic.

"We believe greater availability of physical gold and gold related financial products and improved accessibility for international players will likely to increase the trading volume on the Shanghai gold exchange," said Deutsche Bank in a note.

"Indeed, since the SGE began physical gold trading for individuals in 2006, trading volume has increased fourfold," it added. "As a result, we believe China will play an increasingly import role in the global gold market."

Physical gold demand remained firm in India, with a stronger rupee cushioning local buyers from the impact of rising dollar prices. Buying is expected to continue ahead of a festival season starting with Raksha Bandhan on August 24 and continuing until Dhanteras in November.

Recent outflows from gold exchange-traded funds also seemed to have stalled on Thursday, with holdings of the largest, New York's SPDR Gold Trust, rising for the first time since mid-July.

Silver rose in line with gold to $18.45 versus $18.31. Data showed holdings of the world's largest silver ETF, the iShares Silver Trust, fell more than 30 tonnes to 9,151.03 tonnes on Thursday.

Platinum was at $1,568 an ounce against $1,566.75 and palladium at $487.78 versus $492.20.

(Reporting by Jan Harvey; Editing by William Hardy)

Source: http://www.reuters.com/article/idUSTRE66L3OF20100806