TREASURIES-US bonds falter as raging war in Iran lifts oil, inflation outlook

(Adds new comment, yield curve, yield milestones)

* US to deploy more troops to Middle East, pushing oil prices up

* Iran attacks Kuwait oil refinery, adds to market stress

* Inflation swaps show higher consumer prices in next 12 months

* US rate futures start to price in rate hike

By Gertrude Chavez-Dreyfuss

NEW YORK, March 20 (Reuters) - U.S. Treasuries declined for a third straight session on Friday, tracking the broader selloff in UK and European government bonds, as escalating Middle East tensions kept oil prices elevated and reinforced inflation worries.

U.S. two-year yields, which move inversely to prices and have been rising for three straight weeks, were on track for their largest three-day rise since last April. The yield, the most responsive to interest rate expectations, was last up 5.9 basis points (bps) at 3.892%.

The benchmark 10-year yield also increased, up 10.5 bps at 4.388%, on pace for its biggest one-day rise since early June 2025. Earlier in the session, it hit its lowest since July. British and European government bonds sold off as well.

"We saw a fairly decent selloff in European bonds. And that's just forcing a selloff as well in U.S. Treasuries," said Tom di Galoma, managing director of global rates trading at Mischler Financial Park City, Utah. "People are also worried that we're getting close to the weekend and we're going to see severe battle in the Middle East that could cause another push higher in oil."

U.S. crude futures were last up 3% at $98.32 per barrel . Since the beginning of the month, crude futures have risen 47%, the largest monthly gain since May 2020. "The spike in energy prices is pushing inflation expectations higher, particularly in Europe, and this is causing that ripple effect across global bond markets," said Chip Hughey, managing director of fixed income at Truist Wealth in Richmond, Virginia. "There is also a growing consensus that some central banks will potentially need to respond to an inflation shock by not only ending their rate cut cycles, but actually pivoting to rate hikes this year." On Friday, three U.S. officials told Reuters that the U.S. military is deploying a large amphibious assault ship with thousands of additional Marines and sailors to the Middle East. That report came after Iran attacked an oil refinery in Kuwait on Friday and Israel killed a spokesman of Iran's Revolutionary Guards.

U.S. rate futures on Friday began to price in the possibility of an interest rate hike later this year, with markets assigning a 32% chance of tightening by November, according to LSEG estimates, up from virtually zero late on Thursday.

That shift in policy expectations fed through to the curve, which steepened for the first time in five sessions as the spread between two- and 10-year yields widened to 49.6 bps from 45.4 bps late Wednesday.

The curve showed a classic bear-steepening pattern, with long-term yields climbing more rapidly than short-term rates as investors priced in a heightened risk of reaccelerating inflation, at which point the market could anticipate a Fed rate increase to battle the rise in prices.

In other Treasury maturities, the belly of the curve sold off sharply as well. U.S. five-year yields advanced 8.6 bps to 4.006%, while seven-year yields rose to 4.20%, up 10.6 bps.

British 10-year government borrowing costs soared to their highest level since the global financial crisis. The 10-year gilt yield was last up 14.7 bps at 4.995% after earlier hitting 5.022%, the highest since mid-2008.

Germany's 10-year yield also hit the highest since 2011 and was last up 8.6 bps at 3.038%.

"Europe has a larger dependency on imported energy," Truist's Hughey said. "That makes it more vulnerable to supply shortages caused by the conflict in Iran. Meanwhile, the U.S. is a net exporter of energy, which does provide some insulation from oil supply shortages."

Inflation swaps, a measure of the outlook for future consumer prices, hit a six-month peak of 3.3% on Friday. This reflected expectations that the U.S. consumer price index will average more than 3% over the next 12 months. That is in stark contrast with the latest CPI reading of 2.4% year-on-year in February. (Reporting by Gertrude Chavez-Dreyfuss; Editing by Andrei Khalip and Will Dunham)