By Jan Harvey
LONDON (Reuters) - Gold prices have soared to record highs this year on concerns over the euro zone debt crisis, and the metal could be set for another leg higher if the world's biggest economy, the United States, also starts to struggle with its debt repayments.
Gold hit a record $1,575.79 an ounce in May as Ireland and Portugal struggled with unwieldy debt levels and Greece faced fears of default, and it returned to within $20 of that level this week on concerns Italy and Spain could also be affected.
But behind these fears, unease is mounting over the U.S. debt burden. The U.S. Treasury says it will be forced to default on its obligations if Congress does not raise the $14.3 trillion debt ceiling, which caps how much it can borrow, by August 2. Participants say a deal should be in place by July 22.
The prospect of a default is seen as unlikely, but the wrangling over the debt ceiling has highlighted the problems the United States will face in cutting its deficit.
"If the U.S. debt ceiling is not extended in time and the United States were to default even briefly, or if they had to find work-arounds to pay their short-term expenses, that has got to be positive for gold," said David Jollie, an analyst at Mitsui & Co Precious Metals.
"But if they extend the debt ceiling without agreeing any cuts to expenditure or tax increases, you have to say that is inflationary, and therefore positive for gold as well."
Raising the debt ceiling is not an unusual move, having been done 10 times in the past decade. But this time around, Republican Congressmen have said they will not approve such a move unless the Democrats commit to cutting the U.S. deficit.
The Democrats favor doing so via tax increases, among other measures, but this proposal lacks support of Republicans, who are pushing for cuts to spending.
A 75-minute meeting at the White House on Sunday was marked by testy exchanges. Obama and top lawmakers from both political parties will hold their third meeting in as many days at the White House on Tuesday to hammer out a deal.
HAVEN FROM RISK
Arguments that gold is overvalued at current levels are gaining little traction in the current environment. The metal rolled back some gains in May and June as the end of the U.S. quantitative easing program stoked expectations conditions for the metal would deteriorate, but it has quickly bounced back.
A successful resolution of the debt ceiling issue could take the heat out of prices in the short term, but as long as talks go on, the mere threat of a default is helping support the current euro zone debt-driven rally in prices.
While a default is unlikely and would at worst be short term, it could seriously undermine confidence in the dollar as the world's reserve currency, which could drive up interest in gold as an alternative store of value.
Standard & Poor's said it would cut the U.S. credit rating if it misses an August 4 debt payment, potentially undermining the appeal of U.S. Treasuries as investors' haven of choice.
"If we don't come to an agreement and the United States goes into default, the prospects would be very bullish for gold, because its great competitor as a safe haven is U.S. Treasuries," said HSBC analyst James Steel.
"If Treasuries are less than a perfect safe haven, that would be very much for the benefit of gold."
For the moment, Treasuries are being supported by a flare-up in the euro zone debt crisis, but if there is no breakthrough in talks on the debt ceiling, they could come under pressure.
If the default threat drives up Treasury yields, that might be expected to weigh on gold. Low U.S. yields have been a major support for gold, a non-interest bearing asset, in recent years.
But in this scenario, a rise in yields would not necessarily be negative for gold.
"The high yields you have on Irish bonds, Greek bonds, Portuguese bonds haven't hurt gold prices in euro terms," said Tobias Merath, an analyst at Credit Suisse.
"It really depends why yields are up. Is it because the economy is doing well and capital is getting scarce? Is it because the central bank is addressing inflation? That would be the sort of yield increase that is really bad for gold."
"If yields go up because your risk-free rate is no longer that risk-free, this is not something that would really hurt gold," he said.
A successful resolution to the debt ceiling issue could temporarily pressure gold prices, but U.S. debt concerns are unlikely to stop there.
The U.S. economy is a different beast from those on the euro zone periphery, but it suffers from the same malaise -- too much borrowing in the good times, not enough paying back in the bad.
Heavy debt burdens on both sides of the Atlantic are likely to curtail spending from levels in the early part of the 21st century, he said. The resulting curb on growth may limit developed economies' scope to raise interest rates, keeping down the opportunity cost of holding gold.
In the absence of higher rates, inflation may well keep rising, while the United States is also likely to focus on keeping the dollar low against other major currencies.
Gold can hardly fail to benefit.
(Reporting by Jan Harvey, editing by Jane Baird)