GLOBAL MARKETS-Stocks drop, bond yields jump as Iran war fuels central bank rethink

* Major brokerages see greater chance of hikes for BoE and ECB this year

* Markets starting to price in potential for Fed hikes

* Oil prices remain choppy (Updates with close of European markets)

By Chuck Mikolajczak

NEW YORK, March 20 (Reuters) - Global shares slumped for a third straight session and were set for a third consecutive weekly decline on Friday while bond yields climbed on fears the Iran war would keep upward pressure on oil prices and spark inflation.

Iran attacked an oil refinery in Kuwait on Friday and Israel killed a spokesman of Iran's Revolutionary Guards, while three U.S. officials told Reuters that thousands of additional U.S. troops will be deployed to the Middle East.

Iraq declared force majeure on all oilfields developed by foreign oil companies, as military operations in the region have disrupted navigation through the Strait of Hormuz, preventing most of the country's crude exports from moving, oil ministry sources said.

On Wall Street, U.S. stocks slumped, with the S&P 500 energy index the best performer of the 11 major S&P 500 sectors. The S&P 500 energy index is up 3.5% on the week, putting it on track for its 13th straight weekly gain. That week-over-week rally would be its longest since at least the late 1980s, according to LSEG data.

The Dow Jones Industrial Average fell 285.29 points, or 0.62%, to 45,736.14, the S&P 500 dropped 70.00 points, or 1.06%, to 6,536.49 and the Nasdaq Composite tumbled 341.79 points, or 1.56%, to 21,748.90. The S&P 500 is on track for its fourth straight weekly decline, its longest streak of weekly losses since February 2025.

CENTRAL BANKS' POLICY

Global bond yields have moved higher, after policy announcements from multiple central banks this week indicated that interest rates were likely to either be on hold, or could potentially move higher should the war keep pressure on prices.

The yield on benchmark U.S. 10-year notes shot up 10.3 basis points to 4.386% and is poised for its third straight weekly gain.

The 2-year note yield, which typically moves in step with interest rate expectations for the Fed, gained 6.3 basis points to 3.896%, and was on pace for its largest three-session jump since May as markets begin to price in the possibility of rate hikes from the central bank this year.

Markets are now pricing in an increase in rates of 5 basis points this year, after pricing in about 50 basis points worth of cuts in recent weeks.

"There is some belief that the Federal Reserve may raise interest rates this year due to rising inflationary pressures, although I think that would be quite asinine because this is not a demand issue," said Robert Pavlik, senior portfolio manager at Dakota Wealth Management in Fairfield, Connecticut.

"This is a supply issue ... you need to get the Strait of Hormuz opened up and you need to get oil flowing, and that would relieve the pressure on oil prices."

MSCI's gauge of stocks across the globe tumbled 12.55 points, or 1.26%, to 982.61 and is down about 7% over the past three weeks, its biggest drop in nearly a year, and the pan-European STOXX 600 index dropped 1.78% and suffered its third straight week of declines.

Major global brokerages see a higher likelihood of the European Central Bank and Bank of England delivering rate hikes, potentially as early as April, after policymakers warned that the Middle East war is driving renewed inflation risks.

ENERGY CHOKEHOLD

Euro zone government bond yields rose for a third day in a row, while the British 10-year gilt yield soared to its highest since July 2008 at 5.022%. It was last up 14.7 basis points to 4.995%.

Germany's two-year yield, which is up around 55 basis points for the month, was last up 10.2 bps at 2.668%.

U.S. crude rose 2.81% to $98.84 a barrel and Brent rose to $112.27 per barrel, up 3.33% in choppy trade.

Crude was lower earlier in the day after the U.S. outlined moves to manage the oil supply crisis, while leading European nations, Japan and Canada offered to join efforts to secure safe passage for ships through the Strait of Hormuz.

Natural gas prices have also surged, with those in Europe rocketing as much as 35% on Thursday, as Iranian and Israeli strikes hit some of the Middle East's most important gas infrastructure.

DOLLAR FALLS FROM PEAK

The dollar index, which measures the greenback against a basket of currencies, gained 0.28% to 99.56, with the euro down 0.25% at $1.1559. The greenback was poised for its first weekly decline in three.

Two Fed officials said the war and its impact on energy markets were clouding the outlook for the economy and monetary policy, as one policymaker laid out an outlook calling for notably more interest rate cuts than most U.S. central bank officials currently support.

Against the Japanese yen, the dollar strengthened 0.98% to 159.25, moving closer to the 160 mark that has prompted intervention in the currency by Japanese officials.

(Reporting by Chuck Mikolajczak; Additional reporting by Lewis Krauskopf in New York, Sophie Kiderlin in London and Rae Wee in Singapore; Editing by Andrea Ricci, Nick Zieminski and Alison Williams)