* Euro zone bonds in demand after ECB keeps policy unchanged
* Southern European govt bond yields drop 4-5 bps in early trade
* IMF approves 1.6 billion euro Greek loan "in principle"
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Updates with latest prices, context on ECB tapering)
LONDON, July 21 (Reuters) - Euro zone bond yields dropped 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 European Central Bank left its ultra-easy monetary policy unchanged on Thursday and did not discuss clawing back stimulus, though ECB chief Mario Draghi did signal that those discussions would begin in its next one or two meetings.
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 could therefore dampen inflation; the ECB's key goal is to push euro zone inflation up to 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," he said.
Euro zone bond yields, which have been rising in recent times on the back of increased tapering expectations, fell on Thursday and then dropped further on Friday.
Germany's 10-year government bond yield, the benchmark for the region, hit a one-week low of 0.50 percent, down 3 basis points on the day.
Italian, Portuguese and Spanish bonds -- seen as the biggest beneficiaries of the ECB's largesse -- saw their yields fall 6-8 basis points.
The gap between Spanish and German 10-year borrowing costs is at its narrowest level since March 2015 at 94 bps.
The move represents a reversal of the trend of the last three weeks. Euro zone government bond yields rose after Draghi signalled in late June in a speech in Sintra, Portugal, that he was open to policy tweaks.
Expectations grew that the ECB would announce a tapering of its 2 trillion euro bond-buying scheme this autumn, and Germany's 10-year borrowing costs doubled over the course of a fortnight.
Meanwhile, the International Monetary Fund on Thursday approved in principle a 1.8 billion dollar standby loan arrangement for Greece, 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.
Greece's 10-year government bond yields themselves were a touch higher on the day as a potential market return approaches, but at 5.33 percent are well off this year's highs of over 8 percent.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s
(Editing by Kevin Liffey)