TREASURIES-Yields rise after two-year auction meets soft demand

* Two-year yield spikes on soft auction, last at 3.944%

* Yields higher as Iran war persists

* 10-year yield last up to 4.419% (Updates throughout with latest market activity)

By Matt Tracy

WASHINGTON, March 24 (Reuters) - U.S. Treasury yields rose on Tuesday after an auction of two-year notes met underwhelming demand, as market uncertainty persists around the Iran war and elevated oil prices.

Two-year yields edged higher following the auction, reaching a session high of 3.963%. They previously climbed to their highest since July in Monday trading, and were last up 11.3 basis points at 3.944%.

The Treasury Department on Tuesday auctioned $69 billion in two-year notes. The sale's bid-to-cover ratio, a key indicator of demand, came in at roughly 2.45x and was below the average range of 2.5x to 2.6x.

"The (two-year) sector has been a decided underperformer in the Treasury market since the beginning of the war in the Middle East, selling off by as much as 63 bp from pre-war levels on Monday," BMO rates strategists wrote on Tuesday.

Yields inched higher in morning trading as optimism over a quick easing of the Middle East crisis faded, renewing concerns about inflation risks. The benchmark 10-year Treasury yield was last up 8.3 basis points at 4.419%, but short of a near eight-month high touched on Monday. Yields had dipped on Monday from their multi-month highs after U.S. President Donald Trump said he had delayed strikes on Iranian power plants and energy infrastructure, following what he called productive talks with Iran.

But Iran's foreign ministry responded shortly after that there was "no dialogue" between Tehran and Washington, according to state-affiliated media. Iran then announced fresh attacks on U.S. targets, lifting crude oil prices. Major brokerages have revised their 2026 average oil price forecasts as the war rages on and disruptions in shipments from the Strait of Hormuz persist, with Goldman Sachs raising its Brent crude oil forecast for 2026 to $85 a barrel from $77.

"You're seeing energy prices up today, which is driving a lot of the move back up in yields," said Jan Nevruzi, U.S. rates strategist at TD Securities. He added that five-year and seven-year Treasury notes had similarly edged higher on elevated energy prices.

Five-year yields were last up 10.5 bps to 4.055%, while seven-year yields were last up 9.8 bps at 4.241%. A closely watched part of the U.S. Treasury yield curve measuring the gap between yields on two- and 10-year Treasury notes, viewed in the market as an indicator of economic expectations, was last at 46.95 basis points. U.S. rate futures on Friday began to price in the possibility of an interest-rate hike later this year after the Fed and other central banks last week kept rates on hold. Markets last priced in a 89.7% chance of no hike for the Fed's April meeting, slightly lower than in the morning. Data on Tuesday showed U.S. manufacturing and services business activity fell to an 11-month low in March.

(Reporting by Matt Tracy in Washington; Editing by Joe Bavier, Andrea Ricci and Cynthia Osterman)