ANALYSIS-Investors wrestle with Middle East curve ball scenarios

Recasts throughout, adds fresh comments

By Vidya Ranganathan and Yoruk Bahceli

LONDON, March 2 (Reuters) - From bonds to bitcoin, Monday's erratic price moves showed investors struggling to decide if the Middle East conflict is a fringe risk around a power struggle in Iran or a protracted war with ramifications for global trade and inflation.

U.S. President Donald Trump fueled part of the confusion with remarks suggesting the U.S. and Israeli strikes on Iran at the weekend that killed Supreme Leader Ayatollah Ali Khamenei could go on for weeks.

The most telling market reaction was in oil LCOc1 where prices spiked and then fell sharply. Bitcoin BTC= rallied, stock markets across Europe fell but U.S. indexes .SPX were flat to higher, while government bond yields rose everywhere.

"At the moment, market participants seem to be expecting a shorter war lasting only a few weeks," said Commerzbank's chief economist Joerg Kraemer, who also sees this scenario as most likely.

Analysts at J.P. Morgan said in a note they expected a one-to-two-week decline in prices of riskier assets, but that would create "a buy-the-dip opportunity as the market looks through the initial pullback."

Iran has struck back at Gulf cities, with airlines halting flights and tankers carrying oil and other products suspending transit through the key Strait of Hormuz.

The biggest risk for markets is the uncertainty over what happens next in Iran, given the complexities of the Islamic Republic's ruling system.

That then complicates the outlook for oil prices which have gained for weeks and are now hostage to what oil-producing countries do and how the passage of tankers through the Middle East is affected, with big implications for inflation worldwide and even the safety of bonds.

Market scenarios have mostly assumed the fallout would be limited, like it was during last June's "12-Day War" in Iran, rather than the 2022 spike in oil caused by Russia's invasion of Ukraine.

Brent crude LCOc1 was last up 6% at $77 for a gain of nearly 30% so far this year, but remains far below the $100 level analysts reckon it would exceed in a prolonged conflict.

"What we're all worried about is whether we are going to see a repeat of 2022, where both bonds and equities routed as markets deliberated the longer-term energy supply implications," analysts at TS Lombard said.

"The situation remains very much up in the air, but we stand by our original position that this is a squall rather than a full blown oil crisis that tips the global economy into a sustained stagflation regime."

DOES HISTORY REPEAT?

Bond markets belied the calm in other assets, with yields rising as investors trimmed their rate cut bets across major central banks with the inflationary implications of pricier oil in mind.

U.S. Treasury yields shot higher, with 2-year yields US2YT=RR on track for their biggest daily gain in four months as expectations for a Federal Reserve rate cut in June slipped.

Yields on Germany 's 10-year government bond DE10YT=RR, the euro zone benchmark, were set for their biggest jump since December.

"History argues strongly in favor of selling geopolitical risk premium when hostilities start," Barclays analysts said in a note on Saturday. "What worries us is that investors have now learned this pattern and might be underpricing a scenario where containment fails."

They point to other factors that could exacerbate a selloff should the conflict escalate, such as existing concerns around the artificial intelligence boom and private credit markets.

"We see further (market) downside in the coming days," said Jefferies economist Mohit Kumar, who had already derisked last week on concerns markets were complacent on geopolitics.

"At some point we would be ready to buy the dip, but that some point seems far for now."

Some analysts expect Iran will not be able to disrupt trade in the Gulf region and the impact on oil prices will be contained.

"We wouldn’t be surprised if any selloff in the S&P 500 on Monday morning turns into a rally, driven by expectations of lower oil prices once the latest Middle East war ends," said Ed Yardeni, president of New York-based Yardeni Research.

"The price of gold might also round-trip on Monday. Bond yields might fall due to both safe-haven demand and post-war prospects for lower oil prices," he said.

(Reporting by Suzanne McGee in New York, Gregor Stuart Hunter in Singapore, Alun John and Yoruk Bahceli in London; Writing by Vidya Ranganathan and Yoruk Bahceli; Editing by Christina Fincher, Dhara Ranasinghe, Sharon Singleton and Nick Zieminski)

((vidya.ranganathan@thomsonreuters.com;))