By Virginia Furness and Dhara Ranasinghe
LONDON (Reuters) - The euro and euro zone government bond yields fell sharply on Thursday after the European Central Bank changed its rate guidance while banking stocks tumbled as a fresh round of cheap loans was less generous than previous packages.
The ECB pushed out the timing of its first post-crisis rate hike to next year at the earliest and offered banks a new round of cheap loans to keep credit flowing to the euro zone economy.
The decisive policy action sparked a sharp rally in euro zone government bonds, while the euro fell -- moves that gathered momentum after ECB chief Mario Draghi said the central bank had also slashed its growth and inflation forecasts.
"They are being extremely realistic about the challenges ahead of them, and have noted that they have limited ammunition in the toolkit, but you tend to get the biggest bang for your buck when the market least expects it," said Karen Ward, chief market strategist for Europe at JPMorgan (NYSE:JPM) Asset Management.
"So they have rightly used what they have pre-emptively to try and get a market impact, and in terms of that we have the euro and government bond yields down."
Banking stocks were initially cheered by the ECB's decision to launch a new package of Targeted Long-Term Refinancing Operations (TLTROs) but soon sold off.
The euro zone banking sector index was last down 3.6 percent, while the broader stock index was down 0.7 percent.
Analysts put the move down to the ECB's weaker growth forecasts, the change in interest rate guidance and the less generous terms of the new TLTRO.
The ECB's third such lending package will consist of two-year loans partly aimed at helping banks roll over 720 billion euros ($811 billion) of TLTROs extended in 2016 and 2017 that start maturing next year.
The big move in banks today "has to do with the ECB announcement that there's no increase in rates this year", said Martin Moeller, co-head of Swiss and Global equities at UBP.
"Analysts had in their models higher interest rates over time, and that's something they now have to push out, so net-net we are not seeing earnings upgrades to banks."
YIELDS SLIDE
Germany's 10-year bond yield fell to its lowest level since October 2016, down over five basis points to 0.07 percent, while France's 10-year government bond yield also hit its lowest level since late 2016.
The ECB had previously said that rates would be on hold through the summer of 2019, although in recent months weak economic data had already prompted investors to push out their rate hike expectations well into 2020.
(Graphic: Compared ECB statement link: https://tmsnrt.rs/2UtsLX6).
"This certainly goes further than most of us thought that the ECB would," said Aberdeen Standard Investments economist Paul Diggle.
"At this stage it is about as far as the ECB will go toward admitting that the European economy faces some serious headwinds in the months ahead."
The ECB's TLTRO announcement gave a powerful boost to southern European bond markets. Italian and Spanish banks have been among the biggest beneficiaries of previous cheap loan packages.
Italy's two-year government bond yield fell 14 bps to 0.125 percent, its lowest since May 2018. Ten-year Italian yields fell to their lowest since July 2018 at 2.49 percent.
Spain's 10-year bond yield fell to its lowest since October 2016 to 1.047 percent, while Portuguese 10-year bond yields edged down to reach their lowest since at least 1999, at 1.347 percent.
The euro fell 0.65 percent to $1.12345 from above $1.13 before the ECB's policy announcement and then recovered most of its losses.