TOKYO, March 19 (Reuters) - Japanese stocks and bonds

dropped on Thursday, while the yen remained fragile, as

investors weighed the economic impact of the prolonged Middle

East conflict.

Markets were also closely watching how the Bank of Japan

will respond to the war-driven oil shock in its policy decision

later in the day.

The benchmark Nikkei sank 2.9% to 53,640.77, while

the broader Topix slid 2.18% to 3,636.94. The 10-year

Japanese government bond yield rose 4.5 basis

points (bps) to 2.260% as the yen traded at a near two-year low

against the dollar.

"Investors are seeing that the Middle East conflict will

drag on, and they weigh the downward pressure on corporate

earnings," said Wataru Akiyama, a strategist at Nomura

Securities.

Oil prices settled higher on Wednesday and climbed further

in extended trade after Iran attacked several energy facilities

across the Middle East following a strike on its South Pars gas

field, a major escalation in its war with the U.S. and Israel.

A surge in oil prices is weighing on Japan's

import-dependent economy by pushing up inflation, raising

manufacturing costs, and threatening to slow economic growth.

All but two of the Tokyo Stock Exchange's 33 industry

sub-indexes dropped. The shipping and mining sectors

rose 0.4% and 1.2%, respectively, suggesting the

market's bets on the war to prolong, Akiyama said.

The BOJ is expected to keep its interest rates steady after

it concludes a two-day policy meeting later in the day, but

market views on the future rate path are divided as the Middle

East conflict continues to add to domestic price pressures.

"A major focus will be on how much caution the Bank of Japan

will show regarding the risk of upward pressure on inflation,

given its relatively accommodative policy stance," Ataru

Okumura, a senior strategist at SMBC Nikko Securities, said in a

report.

Shares related to chipmakers and artificial intelligence

dragged the Nikkei lower, with Advantest ( ADTTF ) and Tokyo

Electron ( TOELF ) down 4.8% and 2.3%, respectively. SoftBank

Group lost 4%.

The yen was up 0.2% at 159.62 after reaching 159.905

in the previous session, the weakest point since July 2014.