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* ECB in broad agreement next step will be stimulus cut-sources
* Euro rises back towards 2-1/2 year highs
* Govt bond yields broadly higher, pull back from lows
* Banking stocks gain 1.3 pct
By Dhara Ranasinghe and Saikat Chatterjee
LONDON, Sept 8 (Reuters) - The euro, government bond yields and banking stocks in the single currency bloc rose on Friday after Reuters reported that European Central Bank policymakers had agreed at Thursday’s meeting on the need for a cut in stimulus.
ECB officials were in broad agreement that their next step would be to reduce their bond purchases and discussed four options, two sources with direct knowledge of the discussion said.
Possibilities discussed by the ECB included - but are not limited to - cutting asset buys to 40 billion euros a month or 20 billion euros, with extension options including 6 months or 9 months, the sources who asked not to be named said.
The euro jumped around 20 ticks to $1.2069, close to a 2-1/2 year high of $1.2092, it had hit earlier in the day, putting it on track for its biggest weekly gains since end-June.
“Policy withdrawal remains very much on the cards,” said Kit Juckes, a strategist at Societe Generale in London.
Government bond yields rose, reversing earlier falls, as the report prompted bond investors to reassess their expectations for ECB tapering.
Germany’s benchmark 10-year bond yield rose 2 basis points to 0.32 percent, having fallen to its lowest level since late June in early trade at 0.286 percent.
Southern European bond markets, cheered on Thursday by the ECB’s cautious stance, bore the brunt of the selling.
Portugal’s 10-year bond yield, rose 6 bps to 2.80 percent. It slid 13 bps on Thursday and hit 13-month lows early on Friday at 2.70 percent.
Italian and Spanish bond yields were up around 5 bps each .
“It’s all a matter of expectations,” said Mizuho rates strategist Antoine Bouvet.
“We think the market consensus is that the ECB reduces monthly purchases to 40 billion euros for six months but the fact that 20 billion euros is on the table could be potentially scary for markets.”
European stock markets meanwhile were whipped around by euro strength and gains in the banking sector.
The pan-European STOXX 600 index initially dipped as the euro bounced, but erased losses as banking stocks extended their gains following the Reuters ECB report.
Euro zone banks, which benefit from higher interest rates and yields, extended gains to hit a session high, up 1.3 percent.
Analysts say a strong euro could have a negative impact on bank earnings, although that could be mitigated by a boost to their capital adequacy ratio, while strength in the currency accompanied by strong economic growth is seen as positive.
Mediobanca Securities said on Friday that Spanish lenders BBVA and Santander were among the most hit in terms of earnings but were also expected to get a good capital boost, while Deutsche Bank was seen benefiting both on core capital and earnings.
“The euro zone economy is looking healthy to us,” said Iain Stealey, senior fixed income manager at JPMorgan Asset Management. “Euro zone trend growth is supposed to be around 1 percent and we’re growing double that at the moment.” (Additional reporting by Jemima Kelly, Kit Rees and Danilo Masoni; Editing by Gareth Jones)