* Bond yields drop while focus shifts to central banks

and oil prices pause

* Traders indicate an ECB rate hike in July and an 80%

chance of a second increase in 2026

* Economists still wary of ECB tightening

(Adds comments, background)

By Stefano Rebaudo

March 16 (Reuters) - Bund yields slipped on Monday but

remained near their highest in almost 2-1/2 years, as the Middle

East conflict stoked inflation fears and reinforced expectations

of monetary tightening ahead of a busy week of central bank

meetings.

Oil prices edged 0.40% higher on Monday and were up more

than 40% this month as Tehran halted shipments through the

Strait of Hormuz in retaliation for U.S. and Israeli air

strikes.

The Federal Reserve will announce its policy decision on

Wednesday, with the European Central Bank, the Bank of England

and the Bank of Japan following a day later.

Central banks are expected to hold interest rates this

month, but investors will focus on any clues as to how

policymakers might respond to the economic impact of the

conflict in the Middle East.

Yields on Germany's 10-year government bond, the

euro zone benchmark, fell 2.5 basis points (bps) to 2.95%. On

Friday they touched 2.994%, the highest level since October

2023.

Money markets are fully pricing one European Central Bank

rate hike by July, along with an 80% chance

of a second increase by year-end.

The market is anticipating a proactive, zero-tolerance ECB that

is willing to sacrifice growth in order to defend its inflation

credibility, but most economists believe that the Governing

Council will not support a near-term rate hike.

"The euro area is facing a new inflation shock, but that is

still likely to be temporary and modest," Berenbergchief

economist Holger Schmieding said.

"It's a political bet, namely that Donald Trump has no

interest in high petrol prices for American consumers for a long

time and he will look for a way out," he added.

A COUPLE OF 'INSURANCE' HIKES CANNOT BE RULED OUT

Citi reiterated this morning that a couple of ECB

"insurance" hikes can't be fully ruled out, even though its base

case remains that uncertainty justifies the central bank

inaction.

Germany's 2-year yield, more sensitive to

expectations for policy rates, was flat at 2.43%, having hit

2.476% last week, the highest since August 2024.

Italy's 10-year government bond yield fell 5 bps

to 3.74%.

Although German bonds have lost some of their safe-haven appeal,

spreads widened when war developments hurt risk appetite.

The 10-year yield spread between Italian government bonds

and Bunds was at 77 bps, widening from 63 bps before the U.S.

and Israel launched the war on Iran. The spread had narrowed to

53.50 in mid-January, its smallest since August 2008.

The prospect of policy rate hikes has halted the tightening

of euro area yield spreads, as it could bring fiscal concerns

back into focus.

However, with the 5-year-5-year inflation swaps still close to

2%, there are no market signs of inflation expectations becoming

unanchored, ING argued in a research note.

The market gauge of euro zone medium-term inflation

expectations was at 2.2%, its highest level since

March 2025.

French 10-year bonds were yielding 68 bps more than Bunds

, compared with 58 bps before the conflict began.

(Editing by Kirsten Donovan and Andrew Heavens)