Updates with late prices

By Suban Abdulla

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 GB2YT=RR, 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 GB10YT=RR fell as much as 15 bps to 4.905%, the lowest since April 23, and was last down 13 bps.

Thirty-year gilt yields GB30YT=RR 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 GB30YT=RR 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.