Bond markets gripped by oil-driven inflation fear, traders see possibility of ECB hike this year

* German two-year yields set for biggest two-day jump in 10 months

* Oil jump fans inflation worries

* Traders see small chance of ECB rate hike by year-end (Updates throughout)

By Alun John

LONDON, March 3 (Reuters) - Government bond markets from Germany to the United States and Britain sold off sharply on Tuesday as the air war in the Middle East drove oil prices higher and rekindling inflation fears.

In the euro area, traders priced a small chance of a European Central bank rate hike this year, while Chief Economist Philip Lane told the Financial Times in an interview that a prolonged war in the Middle East could cause a substantial spike in euro zone inflation and reduce economic growth.

The central bank is set to remain firmly on hold for now, but markets now see a small chance of a rate increase by year end, having earlier priced roughly a 40% chance of a rate cut.

The rise in rate-sensitive two-year German bond yields was echoed across the currency bloc as well as in the U.S. Treasury market and UK gilts.

Germany's two-year bond yield rose nearly 8 basis points to 2.16%. It is up 15 basis points since Friday's close, set for its biggest two-day jump in 10 months.

Germany's benchmark 10-year yield rose 6 bps to 2.76%.

"The ECB will look through the first-order impact but persistence of higher prices is key," said Kenneth Broux head of corporate research FX and rates at Societe Generale in a note.

He said second round inflation effects via wages would present ECB President Christine Lagarde with "an awkward route forward and a potential rate hike."

Britain's two-year gilt yield meanwhile rose 12 basis points to 3.77% as investors slashed bets on a rate cut this month to just a 25% chance from around 75% on Friday.

The U.S. 2-year yield rose 5 bps to 3.53%..

Europe imports the bulk of its oil and gas, and Brent crude rose 4.3% to $80.86 a barrel on Tuesday. Benchmark European wholesale gas prices closed around 35-40% higher on Monday, and were higher again on Tuesday.

Analysis by the ECB from December suggests that a permanent oil price spike of this magnitude could lift inflation by 0.5 percentage point and lower growth by 0.1 percentage point.

Euro zone inflation now stands at 1.7%, below the bank's 2% target, suggesting that a small jump in price growth is unlikely to trigger policy action, especially since monetary policy acts with long lags and is considered powerless against near-term swings in prices.

(Reporting by Alun John, Editing by Louise Heavens and Dhara Ranasinghe)