(Updates to early afternoon trading, adds new comment)

By Yoruk Bahceli and Canan Sevgili

LONDON, July 10 (Reuters) - Euro zone bond yields fell on

Friday as oil prices retreated and investors judged the latest

flareup in the Iran conflict was unlikely to escalate, although

it left German yields on track for their biggest weekly rise in

more than a month.

Germany's two-year bond yield, which is sensitive to

European Central Bank interest rate expectations, fell 1 basis

point to 2.64% but was still up around 10 basis points on the

week, marking its largest weekly increase in five weeks.

The benchmark 10-year Bund yield dropped 2 bps to 3.03%,

after touching a more than one-month high of 3.09% on Thursday.

It was also up roughly 10 basis points this week, on course for

its biggest rise since early May.

Earlier this week, renewed U.S.-Iran tensions prompted

traders to increase bets that the ECB could deliver two

additional rate hikes this year following its June move, pushing

bond yields higher.

By Friday, however, markets stabilised as Brent crude

slipped to around $75 a barrel having briefly climbed above $80

earlier in the week. A U.S. official said Washington remained

committed to finding a resolution with Iran and that "technical

talks continue".

Money markets were pricing in around 32 basis points of ECB

tightening by year-end on Friday, implying one further

quarter-point rate increase and roughly a 30% chance of a second

move. That was down from about 36 basis points earlier in the

week.

But while the week's move was partly a response to higher

energy prices and inflation expectations, that was not the only

thing in the mix, particularly for longer dated bonds, said Lale

Akoner, global market strategist at eToro.

"While geopolitical tensions have pushed inflation concerns

back into focus, the bigger story is that investors are

demanding greater compensation to hold long-term government

debt," she said.

"Improving euro zone economic data has also reduced

expectations for easier monetary policy, adding further pressure

on bonds."

European bonds on Friday also found support from a rally in

Japanese government debt after reports that Tokyo was exploring

ways to encourage pension funds to increase allocations to

domestic assets. Commerzbank analysts warned such a move could

become a risk for global bond markets if Japanese investors

repatriate funds from abroad.

Japan's finance minister said the government aimed to steer

the country's vast public pension funds towards substantially

greater investment in domestic assets, boosting the yen and

Japanese bonds.

The benchmark 10-year Japanese government bond yield fell

11.5 basis points to 2.760%, its steepest daily decline in more

than a year.

Akoner said any shift in Japanese pension fund allocations

could have broader implications for global markets.

"Japan has long been one of the largest sources of demand

for overseas bonds, particularly U.S. Treasuries. Even a modest

shift toward Japanese government bonds could support the yen and

reduce a reliable source of foreign demand for U.S. debt,"

Akoner added.

"Structural changes in who buys government bonds can have a

much bigger impact on markets than short-term policy headlines."