Recasts, updates market reaction in paragraphs 2-5

LONDON, May 6 (Reuters) - British government bond yields dropped sharply on Wednesday, as investors scaled back their bets on interest rate hikes after officials in Pakistan said the United States and Iran were closing in on a one-page memorandum to end the war.

Two-year gilt yields GB2YT=RR, which are sensitive to interest rate expectations, slumped 18 basis points to 4.339% at 1109 GMT, and were on course for the biggest daily drop in almost a month.

Financial markets trimmed their expectations for increases in borrowing costs by the Bank of England this year, pricing in 49 bps of interest rate hikes, equivalent to two quarter-point rises.

Longer-dated yields also fell, with the 10-year yield GB10YT=RR falling as much as 15 bps to 4.905%, the lowest since April 23.

Thirty-year gilt yields GB30YT=RR were down 14 bps. 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 in line with drops in yields on German Bunds and U.S. Treasuries.

British bond prices have slumped since the start of the U.S.-Israeli war on Iran in late February, and fell 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, confirming and earlier report by the U.S. media outlet Axios.

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" investors were turning more wary of UK bonds because of political turmoil.