UPDATE 4-German two-year bond yield surges above 0% for first time since 2014

(Updates prices, adds details)

By Yoruk Bahceli and Dhara Ranasinghe

March 29 (Reuters) - Germany's two-year yield briefly turned positive for the first time since 2014 on Tuesday as optimism around Russia-Ukraine peace negotiations pushed surging borrowing costs even higher, but yields quickly came off session highs in volatile trading.

Mounting expectations that soaring inflation will prompt major central banks including the European Central Bank to tighten monetary policy faster than previously anticipated has driven bond yields sharply higher in March.

On Tuesday, Ukraine proposed adopting a neutral status in exchange for security guarantees at the latest round of talks with Russia, meaning it would not join military alliances or host military bases.

Russia promised to scale down military operations around Kyiv and northern Ukraine as a confidence-building step, in the most tangible sign yet of progress towards negotiating an end to the war.

The optimism initially pushed Germany's two-year yield briefly above 0% for the first time since late 2014, to as high as 0.050%.

Yields on bonds, a key safe-haven asset, move inversely with prices.

"The sooner the war ends, the less severe the fall in demand in the euro zone as a result of a negative confidence effect. At the same time, no one expects sanctions to be eased. So the supply shock remains," said Arne Petimezas, senior analyst at AFS Group in Amsterdam.

"Tighter ECB policy fits into that narrative, so the Schatz is under pressure," Petimezas added, referring to Germany's two-year bond.

Germany followed France, where the two-year bond yield rose to as high as 0.0670%, breaking above zero for the first time since January 2015.

Bond yields jumped as money markets ramped up their bets on an ECB interest rate hike even further, at one point pricing in nearly 70 basis points of hikes by December, compared to 60 basis points earlier on Tuesday.

However, yields came down from session highs with a sharp fall in U.S. Treasury yields shortly after. Germany's two-year yield was up 7.3 bps to -0.036% by 1508 GMT. Money markets also went back to price 65 bps of ECB hikes by year-end.

Analysts said the turnaround in bond yields may be driven by the fall in oil prices following the news out of Ukraine.

Lower oil prices leading to lower inflation and less policy tightening and lower yields "is a decent theory on paper, but I don't want to read too much into one afternoon's price move", said Michael Brown, head of market intelligence at Caxton.

Germany's 10-year yield, the euro area benchmark, was last up 7.1 basis points after rising as much as 15 basis points on the day and touching its highest level since early 2018 at 0.741%.

Southern European 10-year bond yields were 3-7 bps higher after rising to their highest levels since early 2020 in Italy, Greece and Portugal , while Spanish yields reached their highest since late 2018 at 1.591% .

Analysts said inflation numbers out later this week from some euro zone countries may also be adding to unease in bond markets given that price pressures have been far more persistent than anticipated.

(Reporting by Yoruk Bahceli and Dhara Ranasinghe; additional reporting by Dnilo Masoni; editing by David Evans, Tomasz Janowski, Paul Simao, Raissa Kasolowsky and Ed Osmond)