(Updated in New York afternoon time)

* Fed funds futures price a 32% chance of a rate hike next

week

* Five-year TIPS breakevens rose to 2.31% from 2.21% on June

24

* Treasury sees soft demand for $13 billion 20-year bonds

sale

By Karen Brettell

NEW YORK, July 22 (Reuters) - Interest rate sensitive

two-year U.S. Treasury yields climbed to a 17-month high on

Wednesday as rising oil prices stoked concerns that renewed

energy disruptions stemming from the escalating conflict with

Iran could reignite inflation and increase the odds of Federal

Reserve interest rate hikes.

The resurgence of tensions in the Iran war has pushed

inflation worries back into focus, following a brief lull after

a ceasefire deal was reached in late June.

Oil prices approached asix-week high as U.S. President Donald

Trump vowed to destroy an Iranian bridge or power plant every

time Iran shoots at a ship in the Strait of Hormuz, raising the

stakes after Iranian-allied Houthis in Yemen threatened a second

vital energy route.

The Fed is increasingly being viewed as leaning hawkish after

policymakers signalled at their June 16-17 meeting that they

expect to raise borrowing costs later this year.

Adding to that view, Fed Governor Christopher Waller said last

week that the central bank may need to raise interest rates "in

the near term" if incoming data show inflation running well

above the 2% target.

"Waller had a hawkish shift in tone, with an emphasis that

was totally independent of energy pass-through," said Will

Compernolle, macro strategist at FHN Financial. "That set a new

anchor for a hawkish policy trajectory that had nothing to do

with how the war evolved."

The 2-year note yield, which typically moves in step

with Fed interest rate expectations, rose 3.68 basis points to

4.298% and reached 4.3105%, the highest since February 2025.

The yield on benchmark U.S. 10-year notes rose 2.65

basis points to 4.655% and reached 4.6606%, the highest since

May 20.

The yield curve between 2- and 10-year notes

flattened to 35 basis points.

Fed funds futures traders currently see a 32% chance of a rate

hike when the central bank concludes its two-day meeting on July

29, and are pricing in 76% odds of an increase by September and

a 90% probability of one by year-end.

U.S. Treasury yields have also been pushed higher by rising

gilt yields, driven by fiscal concerns as Andy Burnham takes

over as British prime minister.

"The focus is on fiscal worries in Europe," Compernolle

said, adding that "there's just a general sell-off in global

sovereign debt."

Inflation expectations have climbed as well. Breakeven rates

on 5-year Treasury Inflation-Protected Securities rose to 2.31%

- implying investors expect annual inflation of 2.31% over the

next five years - after dipping to 2.21% on June 24.

Real yields, which strip out expected inflation, also moved

higher, with 10-year TIPS yields reaching 2.375% on Wednesday,

their highest level since the "tariff tantrum" of April 2025.

The Treasury Department saw soft demand for a $13 billion sale

of 20-year bonds on Wednesday.

The debt sold at a high yield of 5.163%, 0.4 of a basis point

above where it traded ahead of the auction. Demand was below its

recent average at 2.64 times the amount of debt on offer.

The U.S. government will also sell $21 billion in 10-year TIPS

on Thursday.

(Reporting by Karen Brettell; Additional reporting by Medha

Singh; Editing by Nick Zieminski and Chizu Nomiyama )