(Updated in New York afternoon time)

* Fed funds futures price a 36% chance of a Wednesday hike

* Futures imply the benchmark rate could reach about 4.20%

by April

* Fed left rates unchanged last month, signaled a hike later

this year

By Karen Brettell

July 24 (Reuters) - Benchmark 10-year U.S. Treasury yields

dipped from 18-month highs on Friday as oil prices eased, though

investors remained cautious ahead of the Federal Reserve's

policy meeting next week, which many believe could bring a

hawkish surprise.

Oil prices have climbed as the Iran war escalates, reviving

concerns over a more prolonged bout of inflation that could push

the central bank toward higher rates.

"The reheating of the situation in the Middle East really

got the market back on track to recognize there is a structural

level of inflation that's too high, that's going to require

higher rates," said Robert Tipp, chief investment strategist and

head of global bonds at PGIM Fixed Income.

Fed funds futures traders are now pricing in a 36% chance of

a hike at the conclusion of the Fed's two-day meeting on

Wednesday, up sharply from 13% a week ago, according to the CME

Group's FedWatch Tool.

The 2-year note yield, which typically moves in

step with Fed rate expectations, fell 2.94 basis points to

4.331%. It is heading for its largest one-week basis point

increase since May 11 at 16 basis points.

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

fell 1.98 basis points to 4.683%. It is also on track for its

largest weekly increase since May 11 with a gain of 14 basis

points. The yield curve between 2- and 10-year yields

steepened to 34.8 basis points.

Traders had pared back bets on rate increases after the

United States and Iran reached a deal last month aimed at ending

the war. Those bets were reignited, however, as the war

reaccelerated.

U.S. missiles struck targets across Iran on Friday, reaching as

far as its Caspian coast, after President Donald Trump vowed

"major military punishment" against Iran and its Houthi allies

in Yemen for extending the war to a second major shipping

chokepoint at the mouth of the Red Sea.

Consumer price inflation data for June, released last week,

showed prices moderating more than economists had expected,

boosting hopes that the worst of the price pressures was over.

Still, one data release is unlikely to derail hikes as long

as inflation remains well above the Fed's target and the economy

stays strong, Tipp said.

Adding to price pressure worries, the U.S. imposed new tariffs

of 10% and 12.5% on goods from 60 trading partners, including

the EU and China, just as a temporary 10% global tariff expired.

Futures pricing shows expectations that the benchmark rate

will rise to around 4.20% by April, from its current band of

3.50% to 3.75%.

Fed Chairman Kevin Warsh's preference for less forward guidance

is adding to the uncertainty surrounding the Fed's response to

this new bout of higher energy costs.

The Fed held interest rates steady last month, but policymakers

expect a hike in borrowing costs later this year amid growing

concerns about inflation lodged above the U.S. central bank's 2%

target.

Data on Friday showed that activity in the vast U.S. services

sector accelerated in July, aided in part by spending around the

FIFA World Cup and the Independence Day holiday.

Separately, sales of new U.S. single-family homes snapped a

two-month skid in June, but higher mortgage rates and

affordability challenges restrained the rebound and continue to

sideline potential buyers from the housing market.