TREASURIES-Yields rise as oil surge stokes inflation worries

(Updates to afternoon US trading)

* Oil price surge on Iran conflict raises inflation concerns

* February ISM manufacturing PMI 52.4 vs forecast 51.8

* Fed rate cut expectations dip amid rising inflation worries

By Chuck Mikolajczak

NEW YORK, March 2 (Reuters) - U.S. Treasury yields shot higher on Monday after military strikes in Iran by the U.S. and Israel, followed by counter-strikes by Tehran across the Middle East, sparked a jump in oil and gas prices and raised fears about escalating inflation. The U.S.-Israeli air war against Iran expanded with no end in sight, as Israel attacked Lebanon in response to strikes by Hezbollah and Tehran kept up its missile and drone attacks on Gulf states.

U.S. President Donald Trump said the attack was ordered to stymie Iran's nuclear and ballistic missile program that he said was growing rapidly, but gave no indication the military operation would end soon.

"At this point, oil is going to be a problem, obviously gas is going to be a problem, so that will probably delay some kind of Fed cut going forward," said Tom di Galoma, managing director at Mischler Financial Group in Stamford, Connecticut.

"As far as the run-up that we saw in the last couple weeks, a lot of it was due to the fact that people sort of felt that after the Olympics and after the State of the Union, that there was going to be some kind of movement into Iran because the negotiations weren't going right." Expectations for a rate cut from the Federal Reserve at its June meeting - which the market had been pricing in as the first with a more than 50% chance for a cut of at least 25 basis points - fell to 45.2% from 57.4% in the prior session, according to CME's FedWatch Tool.

Oil prices rose as much as 13% but have since pared gains, with U.S. crude settling up 6.28% to $71.23 a barrel and Brent settling at $77.74 per barrel, up 6.68% on the day.

The two-year U.S. Treasury yield, which typically moves in step with interest rate expectations for the Fed, surged 11.1 basis points to 3.49% and was on track for its biggest daily gain since June 6. Yields extended gains after the Institute for Supply Management (ISM) said its manufacturing PMI was little changed at 52.4 last month compared with 52.6 in January, the second straight month above the 50 level which indicates expansion. Economists polled by Reuters had forecast a 51.8 reading.

In addition, the ISM showed a measure of prices paid by factories for inputs rose to the highest level in nearly 3-1/2 years, further fanning inflation concerns.

"For the manufacturing recovery to turn into a renaissance will require the conflict with Iran to be short-lived instead of the feared protracted quagmire," said Brian Jacobsen, chief economist at Annex Wealth Management in Menomonee Falls, Wisconsin.

The yield on the benchmark U.S. 10-year Treasury note climbed 8.6 basis points to 4.048%, and was also on pace for its biggest daily rise since June 6.

The yield on the 30-year bond advanced 6.6 basis points to 4.699%.

A closely watched part of the U.S. Treasury yield curve measuring the gap between yields on two- and 10-year Treasury notes, seen as an indicator of economic expectations, was at a positive 55.4 basis points.

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at 2.487% after closing at 2.439% on Friday.

The 10-year TIPS breakeven rate was last at 2.268%, indicating the market sees inflation averaging about 2.3% a year for the next decade. (Reporting by Chuck Mikolajczak, additional reporting by Amanda Cooper in London and Rae Wee in Singapore. Editing by Hugh Lawson, Mark Potter and Andrea Ricci )