* Oil slips about 2.2% to $86.38 a barrel after Monday's

near-9% drop

* Money markets pricing in a roughly 68% chance of September

ECB rate hike

* Germany's two-year bond yield down 1.8 basis points to

2.7635%

By Sophie Kiderlin

LONDON, July 28 (Reuters) - Euro zone bond yields steadied

on Tuesday, having fallen for the past two sessions along with

oil prices, as traders turned their attention to this week's

U.S. Federal Reserve meeting.

Germany's 10-year government bond yield, the

benchmark for the euro zone, was last flat on the day at 3.13%.

Last week, it hit 3.2118%, its highest level since 2011, but has

been declining since then as a lull in hostilities between the

U.S. and Iran brought the price of benchmark Brent crude oil

below $87 a barrel.

That eased traders' worst fears of a surge in inflation that

would cause central banks to raise interest rates aggressively,

weighing on economic growth.

President Donald Trump said on Monday the United States was

having "good talks" with Iran, and there was a chance of a deal,

but threatened to restart strikes unless negotiations deliver.

Iran denies seeking to resume talks with the United States.

"At the end of the day, there has been no improvement in

tanker flows through the Strait of Hormuz ... Furthermore, even

in the event of a deal, one would expect that the market will

need to continue to price in a large risk premium, given that

recent events have demonstrated how quickly a deal can unravel,"

ING commodities strategists said in a note.

Higher energy costs have been a key driver of inflation

concerns across the euro zone, especially given the European

economy's vulnerability to imported energy.

Later this week, a reading of second-quarter gross domestic

product and a flash estimate of July inflation for the euro zone

could shed further light on the impact of the war on the bloc's

economy.

CENTRAL BANK EXPECTATIONS

Before then, however, comes the Federal Reserve meeting, which

wraps up on Wednesday.

While expectations are still tilted towards rates staying

steady, market pricing for a policy tightening has picked up in

recent days, and a growing number of major brokerages are

warning that policymakers could raise rates.

In June, the European Central Bank raised interest rates by 25

basis points to tame inflationary pressures. Policymakers kept

rates steady at their July meeting last week but left the door

open for a potential increase in September.

Money markets have slightly scaled back expectations for further

tightening from the ECB in recent days. However, they were last

still pricing in a roughly 70% probability of a September rate

hike, with the possibility of another increase later in the

year.

Germany's two-year government bond yield, which is more

sensitive to rate expectations, was down 1.8 basis points on the

day at 2.76%. It reached a two-year high of 2.8938% last week.

Markets are also focused on central bank action elsewhere this

week, with the Bank of England and Bank of Japan also due to

make their latest interest rate decisions.