* Bonds in high demand after ECB keeps policy unchanged
* Euro hits 2-year highs against dollar
* Southern European govt bond yields drop 3-10 bps
* IMF approves 1.6 billion euro Greek loan “in principle”
* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices)
By Abhinav Ramnarayan
LONDON, July 21 (Reuters) - Euro zone bond yields fell across the board on Friday after the single currency hit a two-year high against the dollar, leading investors to question the timing of the European Central Bank’s planned withdrawal of stimulus.
The ECB left its ultra-easy monetary policy unchanged on Thursday and did not discuss clawing back stimulus, though ECB chief Mario Draghi signalled that discussions would come in the autumn.
Policymakers now see October as the most likely date to decide on the future of the ECB’s asset buys and consider December, an option flagged by staff, as too late, four sources with direct knowledge of the discussion told Reuters.
Investors are turning their attention to the strength of the euro and the effect it may have on the pace of monetary policy tightening, analysts said.
The single currency rose on Friday to $1.1677, its strongest against the dollar since August 2015. A stronger euro would hit euro zone exporters and hurt growth. Further currency strength could also dampen inflation by keeping down import costs.
The ECB targets inflation at just below 2 percent.
“If euro strength remains where it is for a long period of time, it has the potential to derail the ECB’s plans because of the effect on inflation,” said Mizuho strategist Antoine Bouvet.
“On a trade-weighted basis, we are now back to where we were before quantitative easing began. This is a problem for Draghi.”
Euro zone bond yields, which have been pushed up in the past three weeks on heightened expectations for ECB tapering in the months ahead, extended Thursday’s falls.
Germany’s 10-year government bond yield, the benchmark for the region, fell 3.5 basis points to a one-week low of 0.50 percent.
Italian, Portuguese and Spanish bonds - seen as the biggest beneficiaries of the ECB’s largesse - saw their yields fall 4-10 basis points.
The gap between Spanish and German 10-year borrowing costs is at its narrowest level since March 2015 at 94 bps. Spanish and Italian bond yields were set for their biggest weekly falls in over a year, down about 20 bps each.
Greece was also in focus after the International Monetary Fund on Thursday approved in principle a $1.8 billion standby loan arrangement for the country, making a conditional commitment to help underpin Athens’ long-running bailout programme for the first time in two years.
Greece is believed to be considering a bond issuance next week, a deal that would represent its first foray into debt markets since 2014. Greece’s debt agency has appointed banks for the deal according to International Financing Review, a Thomson Reuters publication.
Ratings agency S&P Global is due to review its B- rating on Greece on Friday evening.
Greek bond yields were a touch higher as a potential market return approaches.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets
Reporting by Abhinav Ramnarayan; Additional reporting by Dhara Ranasinghe; editing by Mark Heinrich