* Oil price retreats from highs, eases bond yield

pressure

* Geopolitical tensions affect inflation and rate outlook

* Central banks face challenges with rate decisions

(Updates with European afternoon trading)

By Niket Nishant

LONDON, March 9 (Reuters) - Germany's 10-year bond

recovered from a sharp selloff on Monday as oil prices retreated

from their highest level since 2022, although fears of a

prolonged fallout from the widening war in the Middle East kept

investors on edge.

Investors have largely looked past the safe-haven appeal of

global bonds, focusing instead on inflation risks as the

U.S.-Israel war on Iran disrupts traffic through the Strait of

Hormuz, a crucial oil shipping route.

Oil prices had surged to more than $119 a barrel in early

trade on Monday, but edged back from their highs on expectations

that G7 countries could release emergency oil reserves in an

attempt to lower prices.

G7 nations held off from making a decision to release their

reserves but said all tools were available to stabilise the

market.

Germany's 10-year government bond yield, the

bloc's benchmark, was little changed at 2.863%. It hit 2.931%

earlier, its highest level in a year, and is still up over 40

basis points (bps) since the outbreak of the war.

The supply shock has lifted crude prices by about 40% since

the first wave of attacks on Iran, threatening the inflation

outlook.

Capital Economics said that a useful rule of thumb is that a

5% rise in oil prices adds around 0.1 percentage points to

developed market inflation.

"One after another, geopolitical catastrophes that kept

scenario planners awake for decades have delivered

smaller-than-expected (oil) price spikes. But a Strait of Hormuz

shutdown is a big deal," said Kevin Book, an expert at the

Center for Strategic and International Studies.

RATE OUTLOOK MUDDLED

Higher crude prices have compounded investor unease about

the rate outlook for central banks, reviving the possibility of

policy tightening.

A market-based measure of euro zone long-term inflation

expectations jumped as high as 2.2658%. It was last at 2.1459%.

Money market traders have moved to fully price in one

quarter-point rate hike from the European Central Bank in 2026,

with around a 25% chance of a second. Prior to the conflict,

markets had priced about a 40% chance of a rate cut by

year-end.

The yield on Germany's interest-rate-sensitive two-year bond

rose 2 bps to 2.330%, having earlier reached 2.476%,

a level last seen in August 2024.

The risk of higher borrowing costs is particularly acute in

countries reliant on energy imports, such as Britain. The yield

on the two-year British government bond jumped as

high as 4.239%, although it was last at 3.985%.

TS Lombard economist Dario Perkins expects that central

banks planning to leave rates on hold will probably stick to

that plan, but those planning to cut face the biggest headache.

"Inflation is already overshooting their targets, and - in

their minds - that makes expectations 'more fragile'," Perkins

said. "For now, all rate cuts have been postponed."

U.S. President Donald Trump said the U.S. Navy could escort

ships in the Gulf. However, it remains unclear whether the Navy

has the capacity to do so, as some of its vessels are currently

conducting strikes against Iran and intercepting its missiles.

Iran has named Mojtaba Khamenei to succeed his father Ali

Khamenei as supreme leader, defying Trump and underscoring

hardliners' grip in Tehran.

(Reporting by Niket Nishant and Samuel Indyk; Editing by Pooja

Desai and Ros Russell)