* Sky-high mkt expectations disappointed with Draghi
* German, Italian yields up after initial fall
* Euro hits 2-yr low, then rallies; stocks erase gains (Adds details, new quote)
By Josephine Mason and Tommy Wilkes
LONDON, July 25 (Reuters) - The rally in European government bond and stock markets ran out of steam on Thursday after European Central Bank President Mario Draghi signalled another round of monetary easing but expressed caution about pulling the trigger too quickly.
Draghi told reporters "this (economic) outlook is getting worse and worse", increasing the need for stimulus. But investors latched on to his comment that the ECB wanted to see more projections of how the economy was performing before taking action.
Investor expectations for easing had been sky-high ahead of Thursday's meeting, with some even expecting the ECB to cut its deposit rate immediately after a batch of gloomy economic data in powerhouse Germany and falling inflation forecasts.
"Some people expected a cut today already and Draghi indicated they didn’t really even discuss a cut today so that’s what surprised the market and that's why we’re seeing this reversal," said Jeremy Gatto, investment manager in the cross asset solutions team at Unigestion, while adding that the bigger picture was one of a deteriorating macroeconomy in 2019.
The 10-year and 30-year German government bond yields initially hit new record lows as the ECB flagged sweeping stimulus measures including rate cuts, asset-purchases and tiered interest rates for banks. Its guidance that rates would remain at "present or lower levels" at least until mid-2020 was seen as meaning a cut would come in September.
Investors cheered those signals, sending the spread between German and riskier Italian 10-year bond yields -- widely seen as a key measure of euro zone risk sentiment -- to its tightest since May 2018 and briefly sending stocks surging.
But the gains did not last, with both German and Italian yields ending the day higher.
The euro, which initially fell to 26-month lows of $1.1101 , also recovered to $1.1159, up 0.2% on the day. It jumped 0.7% versus the Swiss franc.
European banking stocks briefly rallied to their highest since May 20 after the ECB signalled it may introduce tiered deposit rates to provide respite to the struggling sector.
The minus 0.4% deposit rate is effectively a charge banks must pay to park excess reserves securely at the ECB, from which tiering would partially exempt them, boosting lenders' profits.
The banking index rose as much as 1.65% but the rally then fizzled and closed up 0.22%. Broader euro zone equities fell 0.44%.
Money markets' gauge of long-term inflation expectations ticked higher, however, with five-year/five-year forward inflation swaps -- watched closely by the ECB --trading as high as 1.3582, the highest since May.
Crucially, Draghi said the ECB's inflation target should not be viewed as a 2% cap, talking instead of a "commitment to symmetry in the inflation aim".
Essentially that can be seen as willingness to keep policy ultra-loose for a much longer period of time during which inflation might be above the target.
"The ECB might have disappointed those looking for an immediate rate cut after the spate of weak sentiment data, but their statement of intent is clear: easing is coming, and soon," said Hetal Mehta, Senior European Economist at Legal & General Investment Management.
She said that by flagging the possibility of a tiered deposit rate and more QE bond-buying on top of rate cuts, the bank was trying to show it had plenty of ammunition left to fight the downturn and raise inflation levels.
"Shoring up their credibility is clearly a key priority," Mehta added.
Additional reporting by the London Markets Team Editing by Catherine Evans and Elaine Hardcastle