TREASURIES-US bonds drift higher, but Middle East caution lingers; Fed in focus

* FOMC statement ahead; market keen to hear remarks on Iran impact

* US rate futures price in one cut in 2026

* US 2/10 yield curve flattens for 2nd straight day

* US Treasury to auction $13 billion in 20-year bonds

By Gertrude Chavez-Dreyfuss

NEW YORK, March 17 (Reuters) - U.S. Treasuries edged higher on Tuesday, tracking gains in equities, as risk sentiment improved after Israel reported the killing of Iran's top security official, though markets remained wary with Iran rebuffing de-escalation messages from intermediaries.

U.S. yields, which move inversely to prices, fell across the curve, with yields on five- to 30-year Treasuries down for a second straight session and two-year yields declining for a third day. Last week's selling pressure on Treasuries eased, as bond investors priced in a short-lived conflict, with the view that a swift, contained war would push oil prices lower and limit inflationary pressures. That assessment was tested by developments in the Middle East. Israel said on Tuesday Iran's security chief, Ali Larijani, was killed, as well as Gholamreza Soleimani, who led the volunteer Basij militia, which plays a major role in domestic security.

IRAN LEADER REJECTS DE-ESCALATION But any initial improvement in sentiment from that news was tempered by comments from a senior Iranian official who said the new supreme leader had rejected de-escalation offers conveyed by intermediaries, insisting Israel and the United States first be "brought to their knees."

Against that unsettled backdrop, investors are also looking ahead to comments from the Federal Reserve on the conflict and its implications for interest rates and the broader economy. The policy-setting Federal Open Market Committee, which began its two-day meeting on Tuesday, is widely expected to leave its benchmark overnight rate unchanged in the 3.50%-3.75% range.

Markets will be keen for comments on how policymakers assess the Iran conflict in the context of the Fed's dual mandate of price stability and maximum employment.

"Because of the higher level of uncertainty, you can expect the Fed to come in and not change anything," said Olumide Owolabi, head of the U.S. rates team at Neuberger Berman in Chicago.

"It's a quarterly meeting so you expect the dot plot to come up again. We really don't expect a whole lot of changes from that, at least from the levels that were given in December. Maybe we see inflation changing a little bit higher."

'DOT PLOT' The "dots" from the December meeting, when the Fed last cut interest rates to the current range, showed just one further 25-bp easing this year. The median policymaker's estimate of a neutral level that neither brakes nor stimulates the economy remained at 3%.

U.S. rate futures on Tuesday priced in just one Fed cut this year, or about 26 bps, from 55 bps before the Iran war, according to LSEG estimates.

In midday trading, the benchmark 10-year yield dipped 2.2 basis points to 4.198%. On Monday, it posted its largest daily decline since mid-February.

U.S. 30-year yields also slid, down 1 bp at 4.848% . It had its biggest daily drop on Monday since February 12.

U.S. two-year yields, which reflect interest-rate expectations, were also down, slipping 1.1 bps to 3.669%. The yield has slid nearly 10 basis points over the last three days, the largest three-day fall since late November.

The U.S. yield curve flattened for a second straight session, with the spread between two-year and 10-year yields narrowing to 52.6 bps from 54.5 bps late on Monday, as investors added duration and pared back front-end easing bets.

The move again reflected a bull-flattening dynamic, with long-term interest rates falling faster than short-dated ones, as markets reassessed the outlook for Fed cuts. Traders increasingly see less scope for aggressive easing, with the recent jump in oil prices reviving inflation concerns and complicating the case for rapid rate reductions.

Market participants are also looking to the Treasury's $13 billion auction of U.S. 20-year bonds, following a mixed reception to last week's supply.

J.P. Morgan, in a research note, said given that 20-year bonds are fairly valued and amid a less supportive technical backdrop, it expects some difficulty in absorbing the issue.

Since last month's auction, 20-year yields have risen about 17 bps, driven by a surge in oil prices tied to the Middle East conflict and a repricing in rate futures toward fewer Federal Reserve cuts. (Reporting by Gertrude Chavez-Dreyfuss Editing by Rod Nickel)