(Adds quote, refreshes Iran, Fed context, updates pricing after

European morning)

* 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 retreated

for a third straight session on Tuesday, as optimism about a

diplomatic resolution to the Iran war and easing oil prices

soothed short-term inflation worries.

Germany's 10-year government bond yield, the

benchmark for the euro zone, was down by less than one basis

point at 3.1192%. Last week, it hit 3.2118%, its highest level

since 2011.

A lull in hostilities between the U.S. and Iran continued after

Washington's abrupt suspension of air strikes on Saturday.

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.

Brent crude futures were around 2.2% lower on Tuesday at

$86.38 a barrel after tumbling close to 9% on Monday.

Still, ING commodities strategists said "we have been in this

position multiple times before, and so the market may be getting

a bit ahead of itself".

"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," they

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.

ECB RATE HIKE EXPECTATIONS

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 68% 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 2.7635%. 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, Bank of Japan and Federal

Reserve all due to make their latest interest rate decisions.

Wednesday's Fed decision will be watched especially closely.

While expectations are still tilted towards rates staying

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

recent days and a growing number of major brokerages are warning

that policymakers could raise rates.