* ECB agrees next step will be stimulus cut, sources say
* Euro rises back towards 2-1/2-year highs
* Govt bond yields broadly higher, pull back from lows
* Banking stocks rally (Updates prices)
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 that their next step would be to begin cutting stimulus.
ECB officials generally agreed their next move would be to cut their bond purchases, and discussed four options, said two sources with direct knowledge of the discussion.
The possibilities discussed included - but were not limited to - cutting asset purchases to 40 or 20 billion euros a month, with extension options including six months or nine months, said the sources, who asked not to be named.
The euro briefly jumped around 20 ticks to $1.2069, near a 2-1/2-year high of $1.2092 hit earlier in the day. It last traded at $1.2033, up 0.1 percent on the day, but was still 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 declines, as the report led investors to reassess their expectations for ECB tapering.
Germany's benchmark 10-year bond yield rose 1.5 basis points to 0.32 percent, having fallen to its lowest level since late June in early trade at around 0.29 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 7 bps to 2.80 percent before pulling back slightly to 2.79 percent, after sliding as much as 13 bps on Thursday and hitting 13-month lows early on Friday at 2.70 percent.
Spanish bond yields were set for their biggest daily rise since late July, almost 6 bps, while Italian yields were up more than 5 bps at 1.96 percent.
"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, whipsawed on euro strength and gains in the banking sector.
The pan-European STOXX 600 index initially dipped as the euro bounced, but then 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 0.8 percent.
Analysts say a strong euro could hurt 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 would be among the most affected in terms of earnings, but were also expected to get a good capital boost. 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 Kevin Liffey