UK gilts pare losses after latest surge on Middle East fears

* Sterling stabilises after earlier drop

* Two-year gilt yields pare losses but up 12 ​bps on ⁠the day

* Investors scale back UK rate hike bets (Updates market moves throughout)

March 9 (Reuters) - A surge in British government bond yields on Monday eased in late trading and investors scaled back their bets on a possible ​Bank ‌of England rate hike later this year due to the war in the Middle East, which looks set to drive up inflation.

Investors see Britain as more exposed ⁠than many other European countries to an energy-price shock due in part to weak public ⁠finances which could come under further strain if ​the government seeks to soften the hit for power users.

Sterling was down 0.2% against the U.S. dollar, having earlier been on track for its biggest daily drop in more than a month.

Gilts again underperformed French, German and U.S. government debt.

The two-year gilt yield soared by as much as 37 basis points ​in early trade ‌to 4.239%. At 1651 GMT, it was up 12 bps. Bond yields move inversely to prices.

Five- and 10-year yields were up 4 and 2 bps respectively after rising 14 bps and 10 bps earlier.

BETS SHIFT FROM RATE CUTS TO HIKE

Investors have now priced out all expectations of a BoE rate cut this year although bets earlier on Monday that the central bank might raise rates by the end of this year ​had been largely reversed.

"With oil prices sharply higher, this will mean UK inflation is higher than expected over the short term," said Hal Cook, senior investment ‌analyst at brokerage Hargreaves Lansdown.

"Many investors had positioned for interest rate cuts in the UK this year as this would have added to returns from gilts. Cuts now seem unlikely, so the market ‌is repricing to reflect this."

ENERGY SHOCK RAISES PROSPECT OF COST-OF-LIVING MEASURES

As well as pushing up inflation, the climb in oil and gas prices could add to pressure on the government to spend potentially billions of pounds in new support measures.

On Sunday, Prime Minister Keir Starmer said supporting working ​people was his priority - a remark investors viewed as a possible hint of measures to shield consumers from higher energy bills despite the existing strain on the public finances.

Finance ‌minister Rachel Reeves said on Monday that a rapid de-escalation of the conflict was the best way to protect households against rising energy bills. She also said the government was ready to support the release of emergency oil reserves in response to a spike in the price of oil.

Lloyds Bank ⁠said a ⁠roughly 2.5 percentage-point rise in inflation would wipe out the government's 23.6 billion-pound ($31.4 billion) fiscal headroom, ‌even before accounting for any new cost-of-living support or the growth hit from higher prices.

David Roberts, head of fixed income at Nedgroup Investments, said the selloff in gilts looked like ​it might soon be overdone and his ​firm had raised the share of gilts in its global fund to 9% from 6%.

"Will the ‌Bank of England raise rates? I think it's highly unlikely if this is a short, sharp shock and oil stabilises and potentially starts to correct over the next six to eight weeks," Roberts said.

"That's something I think not just the Bank of England, but the ECB, and potentially also the Fed, can look through."

Lloyds