TREASURIES-Yields gain as oil rally dims hopes for Fed rate cuts

(Updates to midafternoon, adds market details)

* Oil prices drive inflation fears, Fed rate cut expectations

* Iran warns of $200 oil amid Gulf tensions

* Fed fund futures show reduced rate-cut expectations for 2026

By Karen Brettell

NEW YORK, March 11 (Reuters) - Two-year yields hit a five-month high on Wednesday as higher oil prices stoked inflation fears and pushed back expectations for Federal Reserve rate cuts, with traders largely looking past February consumer price inflation data that was in line with economists' expectations. U.S. consumer prices picked up last month as the cost of gasoline increased in anticipation of an escalating war in the Middle East. The Consumer Price Index rose 0.3% last month after gaining 0.2% in January. Excluding the volatile food and energy components, the CPI gained 0.2% after rising 0.3% in January.

"The thing about this number, however, is that it's very much in the rear-view mirror because it's a February number and there's stuff going on at the moment, which puts upward pressure on prices going forward, clearly given the war in Iran," said Padhraic Garvey, regional head of research Americas and head of global rates and debt strategy at ING. The International Energy Agency on Wednesday agreed to release 400 million barrels of oil, the largest such move in its history, to try to rein in crude prices that have soared due to supply shocks from the U.S.-Israeli war with Iran.

Traders have pushed back expectations of the next Fed rate cut to September on concerns that the war will last longer than hoped. If it continues, higher oil prices are also likely to dent economic growth and send yields lower.

"It's probably going to hurt the economy," said Garvey. However, right now, "the market is saying we're going to have an inflation issue, but this is not necessarily a big hit to activity."

Fed funds futures traders are pricing in 32 basis points in cuts by year-end, down from 41 basis points on Tuesday, indicating rising doubts that the Fed will make two 25-basis-point cuts this year.

Economists at Morgan Stanley expect two Fed rate cuts this year, but note that this assumption "rests on the Fed 'looking through' oil price shocks to headline inflation."

Risks to the outlook include the possibility that firmer inflation and low unemployment lead the Fed to push back cuts, but that it then still cuts to the same level, the economists said.

Alternatively, the Fed could remain on hold for longer if demand erodes more than expected. "In this case, the Fed not only cuts later, but it cuts by more to a lower trough," Morgan Stanley said.

The 2-year note yield, which typically moves in step with Fed interest rate expectations, was last up 6.3 basis points at 3.632%. It earlier reached 3.648%, the highest since September 26.

The yield on benchmark U.S. 10-year notes rose 7 basis points to 4.206% and earlier got to 4.226%, the highest since February 9.

The yield curve between two- and 10-year notes steepened by one basis point to 57 basis points. Benchmark U.S. Treasury yields will drift only slightly higher over the coming months despite potential inflationary pressures sparked by the war in Iran, according to a Reuters poll of bond strategists who have barely changed their forecasts from last month.

There was soft demand for the Treasury's $39 billion sale of 10-year notes, the second sale of $119 billion in coupon-bearing supply this week. The notes sold at a high yield of 4.217%, around half a basis point above where they traded before the auction. Demand was 2.45 times the amount of debt on offer, up from 2.39 times in February, which was the weakest since August.

Interest was weak for the government's $58 billion sale of three-year notes on Tuesday. It will also sell $22 billion in 30-year bonds on Thursday.

(Reporting by Karen Brettell in New York; Editing by Andrei Khalip and Matthew Lewis)