Markets reduce bets on ECB tightening, but still see two hikes by July

* Markets relieved after Trump delays strikes, but caution remains

* Bund yields drop from their highest in almost 15 years

* BofA economist says markets underprice adverse economic impact of the energy shock

By Stefano Rebaudo and Sophie Kiderlin

March 23 (Reuters) - Euro area government bond yields dropped sharply and traders scaled back their bets on future European Central Bank rate hikes on Monday after U.S. President Donald Trump said he would delay striking Iran's energy infrastructure. Trump said he has had good and productive conversations with Iran about a complete and total resolution of hostilities in the Middle East.

Hopes for an end of the Middle East conflict eased inflation fears and saw investors' bets on ECB rate risesdecline, though they were still fully pricing two increases by July. Oil prices fell 10% after Trump's remarks, hours ahead of a deadline that threatened further escalation in the four-week-old conflict.

Germany's 10-year government bond yield, the euro area's benchmark, was down 3 bps at 3.01%, after hitting 3.077% early in the session, its highest level since June 2011.

"The impact has yet to be seen. But obviously markets are breathing a sigh of relief on this news," Chris Beauchamp, chief market analyst at IG Markets, said.

Money markets priced in a depo rate at 2.50% by July , from 2.67% earlier in the session, which implied 2 hikes and about a 65% chance of a third move. The ECB deposit facility rate is currently at 2%. "As we face another inflation shock, central banks want to avoid the criticisms of 2022 that they're too relaxed about inflation, and we can see how that's informing the response today," Harry Allen, macro strategist at Deutsche Bank, said.

However, some economists argue that markets may have overdone expectations of a hawkish response from central banks. "Markets are certainly pricing an inflation and a geopolitical shock, with a stronger U.S. dollar and higher rates across the board," Antonio Gabriel, global economist at BofA, said.

"In our view, more disruptive scenarios for global growth may be underpriced, and growth concerns could prevail, tilting some central banks to look through the shock," he added. Euro zone consumer confidence fell to its lowest level since late 2023 this month, offering early evidence of how surging energy prices may impact the broader economy.

Germany's 2-year government bond yield dropped 8 bps at 2.59%, after reaching 2.764%, its highest since July 2024.

The ECB will not hesitate to tighten policy if the coming energy-driven inflation surge looks like becoming entrenched, keeping price growth elevated for an extended period, ECB policymaker Peter Kazimir said on Monday.

Euro area bond yield spreads versus Bunds tightened after widening significantly in recent sessions, as higher rates will weigh on most indebted countries such as Italy and France. The Italian gap tightened to 84 bps after hitting 103.60 bps early in the session, the highest since June 2025, while the French one dropped to 68 bps after hitting 91 bps the highest since July 2012. (reporting by Stefano Rebaudo and Sophie Kiderlin; Editing by Toby Chopra and Andrew Heavens)