(Updates prices)

* British, German and US two-year yields set for biggest

two-day jump in many months

* Jump in oil and gas prices fans inflation worries

* Traders cut bets on BoE easing this month

* Price in a small chance of ECB rate hike by year-end

By Alun John and Yoruk Bahceli

LONDON, March 3 (Reuters) - Government bond markets from

the euro zone to the United States and Britain sold off sharply

on Tuesday as the air war in the Middle East drove oil and gas

prices higher and rekindled inflation fears.

Sustained higher inflation would likely force central banks

to turn more hawkish. Traders lowered their bets on near-term

rate cuts from the Bank of England and the Federal Reserve and

priced in a small chance of a European Central Bank hike by

year-end.

Bond yields rose as equities sold off, underscoring that bonds

rarely maintain their safe-haven status during episodes of high

inflation.

EURO ZONE INFLATION COULD FACE SPIKE

Chief Economist Philip Lane told the Financial Times in an

interview that a prolonged Middle East war could cause a

substantial spike in euro zone inflation and reduce economic

growth.

The price of rate-sensitive two-year notes fell globally as

their yields surged.

Britain's two-year gilt yield rose 15 basis points to 3.80%,

bringing the increase since Friday's close to 28 bps, setting it

up for its biggest two-day jump since August 2024.

German two-year yields rose 10 bps on Tuesday and are up 18

bps since Friday, the most in a year. U.S. two-year yields were

up 6 bps on the day.

INVESTORS USE 2022 PLAYBOOK

"Investors are basically going back to the 2022 energy-shock

template. That is very fresh in our minds. We saw how large and

persistent the inflation shock was," said Rohan Khanna, head of

euro rates strategy at Barclays, referring to the initial impact

of Russia's full-scale invasion of Ukraine.

He said bond market moves reflected the jump in energy

prices, but the selloff was exacerbated because investors had

previously been positioned for bonds to rally on worries about

AI-driven disruption to the underlying economy.

Europe imports the bulk of its oil and gas. Prices have surged

as shipping through the Strait of Hormuz, which carries around

one-fifth of oil consumed globally and large quantities of

liquefied natural gas, has ground to a near halt.

Brent crude rose 7.5% to $83.60 a barrel on Tuesday.

Benchmark European wholesale gas prices closed around 35-40%

higher on Monday, and were up another 36% on Tuesday.

Benchmark 10-year yields also surged, with Britain's up 16

bps to 4.53%, Germany's up 8 bps to 2.79% and the U.S. up nearly

5 bps to 4.10%.

HOW LONG WILL IT LAST?

The selloff was deepest in Britain, where the BoE is due to

meet later this month. Policymakers are divided over whether to

prioritise inflation or growth.

Traders see just a 20% chance of a cut, versus 75% on

Friday.

Elsewhere, markets no longer fully price in a Federal

Reserve rate cut until September. Traders price in around a 40%

chance of an ECB hike by year-end, having bet on a similar

chance of a cut late last week.

Euro zone inflation rose more than expected to 1.9%

year-on-year, last month, data on Tuesday showed, while a market

gauge of euro zone inflation over the next two years jumped to

just over 2% on Tuesday from around 1.8% on Friday.

Analysis by the ECB suggests that a permanent oil price

spike of this magnitude could lift inflation by 0.5 percentage

points.

Monetary policy acts with long lags, so the focus for

policymakers will be how long energy prices remain elevated and

whether that has second-round effects on wages and prices of

other goods.

The ECB is likely to say it is too early to tell what impact

the conflict will have when it meets later in March, Pictet

Wealth Management's head of macroeconomic research Frederik

Ducrozet said.

For now, short-term bonds have taken the brunt of the

selloff.

But that could change later in the year if governments have

to respond to a sustained rise in energy prices with more

spending, Ducrozet said.

Another supply shock when fiscal policy remains supportive

showed investors should demand more compensation to hold

long-term bonds, TS Lombard analysts said.

"This episode could easily push up term premium again and

today's co-movement in equities and bonds - both down - is

further evidence of why that should be the case."