TREASURIES-US government bonds rise as oil drops, but Iran outlook still murky

* Treasuries yields fall as oil prices retreat, equities rebound

* Iran conflict's impact on bond market remains uncertain

* Fed rate cut expectations reduced amid inflation concerns

* US one-year inflation swaps dip, but still elevated (Adds new comment, U.S. data, updates yields)

By Gertrude Chavez-Dreyfuss

NEW YORK, March 16 (Reuters) - U.S. Treasuries rebounded on Monday, with risk appetite improving, as oil prices retreated and stock markets recovered, although gains were tempered as bond investors continued to assess how long the war in Iran may last.

The benchmark 10-year yield, which falls when prices rise, slid 6.3 basis points (bps) to 4.222% after surging for five straight days. It was on track for its largest daily decline since mid-February. U.S. two-year yields, which reflect interest rate expectations, were also down, dipping 5.4 bps to 3.679%. It was set for its biggest one-day fall since late February.

A sharp rally in oil prices - and the prospect of broader global inflation pressures - drove the surge in yields across the curve last week. U.S. crude futures have spiked by more than 40% since the beginning of March, on pace for the biggest monthly gain since May 2020.

Market players said risk appetite was slightly higher compared to last week as there have been discussions about ending the conflict, or some resolution on how to end it.

"The trend that we saw last week is just reversing a little bit as the market is just trying to figure out, where do we go from here, almost like a little bit of a recalibration," said Jim Barnes, director of fixed income at Bryn Mawr Trust in Berwyn, Pennsylvania.

U.S. officials responding to economic uncertainty over high oil prices predicted on Sunday that the U.S.-Israeli war on Iran would end within weeks and that a drop in energy costs would follow, despite Iran's assertion that it remains "stable and strong" and ready to defend itself.

President Donald Trump also called for a coalition of nations to help reopen the vital Strait of Hormuz and warned that the NATO alliance faces a "very bad" future if its members fail to come to Washington's aid.

"The bond market is not baking in the permanent impairment of the Strait of Hormuz being shut off for a prolonged period or a permanent hit to oil infrastructure," said Ali Hassan, portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico.

He said, "There is no reason in my mind why the market is so optimistic that there is an easy off-ramp to the conflict."

U.S. 30-year yields also slid, down 4.6 bps at 4.862% US30YT=RR, on pace for the biggest daily pullback since February 12.

FLATTER YIELD CURVE

The yield curve was flatter on the day, with the gap between two-year and 10-year yields narrowing to 54.20 bps US2US10=TWEB from 55.8 bps late on Friday.

The curve showed a bull flattening pattern in which long term interest rates are falling faster than short-dated ones. The move largely reflected expectations that the Fed may not cut interest rates as aggressively as previously thought due to the inflationary impact of the recent surge in oil prices.

With inflation rearing its ugly head again, U.S. rate futures have priced in just one Fed cut this year, or about 24 bps, from 55 bps before the war, according to LSEG estimates.

The Fed is set to meet this week, with investors keen to hear the U.S. central bank's outlook on the economy and interest rates in the midst of the ongoing conflict.

Inflation swaps, a gauge of the outlook for future consumer prices, saw a spike to a nearly five-month peak of roughly 3% in one-year maturities last week. This suggested that investors believe that the consumer price index will average about 3% over the next 12 months, higher than the 2.4% year-on-year CPI reading for February.

On Monday, that inflation measure slipped to 2.9% with the drop in oil prices.

Against the backdrop, U.S. economic data remained solid, with Treasury yields earlier extending their rise.

U.S. factory production increased modestly in February as manufacturing remained constrained by tariffs on imports and the conflict in the Middle East could raise operating costs.

Manufacturing output rose 0.2% last month after an upwardly revised 0.8% gain in January, the Federal Reserve said.

Other data on Monday showed sentiment among single-family homebuilders nudging up in March. The National Association of Home Builders/Wells Fargo Housing Market index increased one point to 38 in March, remaining below the 50 break-even point for 23 straight months.

The slight improvement in sentiment likely reflected lower mortgage rates at the start of the year after Trump ordered government-backed mortgage firms Fannie Mae and Freddie Mac to expand purchases of mortgage-backed securities. (Reporting by Gertrude Chavez-Dreyfuss; Editing by Sharon Singleton and Daniel Wallis)