LONDON, May 6 (Reuters) - British government bond yields

dropped sharply on Wednesday, as investors scaled back their

bets on interest rate hikes following reports that the U.S. and

Iran were closing in on agreement on a one-page memorandum to

end the two-month war.

Two-year gilt yields, which are sensitive to interest

rate expectations, slumped as much as 18 basis points to 4.339%

and were 14 bps down at 1513 GMT, on track for their biggest

one-day decline in nearly a month.

Financial markets trimmed their expectations for increases in

borrowing costs by the Bank of England this year, pricing in 52

bps of interest rate hikes, equivalent to two quarter-point

rises, compared to more than 60 bps at the start of the day.

The 10-year gilt yield fell as much as 15 bps to

4.905%, the lowest since April 23, and was last down 13 bps.

Thirty-year gilt yields dropped 16 bps to as low as

5.582% and were 12 bps lower shortly before the close. That was

in contrast to moves on Tuesday, when 30-year gilt yields

rose to their highest since 1998.

Wednesday's move was sharper than drops in yields on German

Bunds and U.S. Treasuries, reversing the outsize rise on Tuesday

which had revived fears about the vulnerability of the public

finances in the run-up to local elections on Thursday.

British borrowing costs have surged since the start of the

U.S.-Israeli war on Iran in late February, and rose further as

an agreement to reopen the Strait of Hormuz did not materialise.

But the U.S. and Iran are nearing a deal to end the war soon, a

source in Pakistan familiar with the negotiations told Reuters

on Wednesday. Iran said it was reviewing a new U.S. proposal.

Jordan Rochester, head of fixed income strategy at Mizuho,

doubted that the boost to bond prices from the deal would last,

as previous mooted peace deals had proven to be "false dawns".

"The market still operates with an assumption the war will

soon be over. But if we get to June with the current status quo,

we suspect the BoE will be joining in with the ECB with a June

hike," he said.

UK LOCAL ELECTIONS ALSO PUTTING BONDS UNDER PRESSURE

Traders are closely watching local elections taking place in

Britain on Thursday which could add to the pressure ​on Prime

Minister Keir Starmer and raise questions about the country's

future fiscal policy if he is replaced as leader of the

governing Labour Party.

"A disastrous showing from Labour could trigger a fresh wave

of selling in UK debt should markets brace for an open revolt in

the ranks and an unceremonious ousting of PM Starmer," said

Matthew Ryan, head of market strategy at financial services firm

Ebury.

"The biggest risk here is a lurch to the radical left under

a new leader, which could raise the spectre of looser fiscal

rules, additional tax hikes and unfunded spending commitments

that bond vigilantes will refuse to tolerate."

But analysts from ING said they were not seeing "clear signs"

that investors were turning more wary of British bonds because

of the potential political turmoil.