TREASURIES-Yields mixed as rebalancing demand offsets war fears, hot US inflation

* Rebalancing demand supports Treasuries despite rising oil prices, geopolitical tensions

* Yields spike after Trump threatens Iran, citing stalled negotiations and possible escalation

* US producer prices rise 1.1% in May, boosting expectations of Fed rate hikes

By Karen Brettell

NEW YORK, June 11 (Reuters) - U.S. Treasury yields were mixed on Thursday as investor demand tied to quarter- and half-year portfolio rebalancing helped offset concerns over an escalating U.S.-Iran war and hotter-than-expected domestic producer price inflation in May.

Rebalancing flows tied to index extensions and other factors are keeping demand for U.S. debt steady despite rising oil prices, said Tom di Galoma, managing director of global rates trading at Mischler Financial Group. Yields briefly spiked after President Donald Trump said the U.S. would hit Iran "very hard tonight" and wanted eventually to take Iran's Kharg Island oil infrastructure hub, after tit-for-tat strikes in the Gulf that have undermined a shaky ceasefire.

"These negotiations just aren't going anywhere and I think that they've got to make a strategic move here," di Galoma said. "We probably are going to see a further escalation." Yields also extended their earlier gains after data showed that U.S. producer prices posted their largest annual gain in 3-1/2 years in May. The Producer Price Index for final demand rose 1.1% during the month, above economists' expectations for a 0.7% gain.

Elevated inflation and a strengthening labor market have fueled bets that the Federal Reserve will raise interest rates later this year. Fed funds futures traders are now pricing in a 68% chance of a hike by December.

The 2-year note yield, which typically moves in step with Fed interest rate expectations, rose 0.4 basis points to 4.131%.

The yield on benchmark U.S. 10-year notes fell 1.2 basis points to 4.528%.

The yield curve between 2- and 10-year notes flattened to 39.3 basis points.

Demand for longer-dated debt will also be tested later on Thursday when the Treasury sells $22 billion in 30-year bonds, the final sale of $119 billion in coupon-bearing supply this week.

The U.S. government saw good demand for a $39 billion sale of 10-year notes on Wednesday and average interest in a $58 billion auction of three-year notes on Tuesday. (Reporting by Karen Brettell; Editing by Paul Simao)