Bond markets dominated by inflation fear, prompting rate-cut bets to fall

* British, German 2-year yields set for biggest two-day jump in many months

* Jump in oil and gas prices fans inflation worries

* Traders cut bets on BoE easing this month

* Price in a small chance of ECB rate hike by year-end (Updates pricing in European mid-afternoon)

By Alun John and Yoruk Bahceli

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

Sustained higher inflation would likely force central banks to turn more hawkish. Traders lowered their bets on near-term rate cuts from the Bank of England and the Federal Reserve and priced in a small chance of a European Central Bank hike by year-end.

Bond yields rose as equities sold off, underscoring that bonds rarely maintain their safe-haven status during episodes of high inflation.

EURO ZONE COULD FACE INFLATION SPIKE

ECB Chief Economist Philip Lane told the Financial Times in an interview that a prolonged Middle East war could cause a substantial spike in euro zone inflation and reduce economic growth.

The price of rate-sensitive 2-year notes fell globally as their yields surged.

Britain's 2-year gilt yield rose 14 basis points to 3.78%, bringing the increase since Friday's close to just over 26 bps, setting it up for its biggest two-day jump since August 2024.

German 2-year yields rose 9 bps on Tuesday and were up 17 bps since Friday, the most in a year. U.S. 2-year yields were last around 3 bps higher after rising as much as 6 bps earlier in the day.

INVESTORS USE 2022 PLAYBOOK

"Investors are basically going back to the 2022 energy-shock template. That is very fresh in our minds. We saw how large and persistent the inflation shock was," said Rohan Khanna, head of euro rates strategy at Barclays, referring to the initial impact of Russia's full-scale invasion of Ukraine.

He said bond market moves reflected the jump in energy prices, but the selloff was exacerbated because investors had previously been positioned for bonds to rally on worries about AI-driven disruption to the underlying economy.

Europe imports the bulk of its oil and gas. Prices have surged as shipping through the Strait of Hormuz, which carries around one-fifth of oil consumed globally and large quantities of liquefied natural gas, has ground to a near halt.

Brent crude rose 8.1% to $84.04 a barrel on Tuesday. Benchmark European wholesale gas prices closed around 35-40% higher on Monday, and were up another 25% on Tuesday.

Benchmark 10-year yields also surged, with Britain's up 13 bps to 4.51%, Germany's up 6 bps to 2.77%, and the U.S. up nearly 5 bps to 4.10% at one point, before paring back to a 2 bps rise.

HOW LONG WILL IT LAST?

The selloff was deepest in Britain, where the Bank of England is due to meet later this month. Policymakers are divided over whether to prioritise inflation or growth.

Traders see just a 28% chance of a cut, versus 75% on Friday.

Elsewhere, interest rate markets showed traders briefly considered a September cut as less than certain. They priced in around a 38% chance of an ECB hike by year-end, having bet on a similar chance of a cut late last week.

Euro zone inflation rose more than expected to 1.9% year-on-year last month, data on Tuesday showed, while a market gauge of euro zone inflation over the next two years jumped to just over 2% on Tuesday, from around 1.8% on Friday.

Analysis by the ECB suggests that a permanent oil price spike of this magnitude could lift inflation by 0.5 percentage points.

Monetary policy acts with long lags, so the focus for policymakers will be how long energy prices remain elevated and whether that has second-round effects on wages and prices of other goods.

The ECB is likely to say it is too early to tell what impact the conflict will have when it meets later in March, Pictet Wealth Management's head of macroeconomic research Frederik Ducrozet said.

For now, short-term bonds have borne the brunt of the selloff.

But that could change later in the year if governments have to respond to a sustained rise in energy prices with more spending, Ducrozet said.

Another supply shock when fiscal policy remains supportive showed investors should demand more compensation to hold long-term bonds, TS Lombard analysts said.

"This episode could easily push up term premium again and today's co-movement in equities and bonds - both down - is further evidence of why that should be the case."

(Reporting by Alun John and Yoruk Bahceli, Editing by Louise Heavens, Dhara Ranasinghe, Amanda Cooper and Barbara Lewis)