UPDATE 2-German court's ECB bond buy ruling hits euro, bonds, stocks

* Ruling on stimulus scheme sparks doubts over ECB policy

* Southern European bond yields jump, spreads widen

* Euro set for biggest 1-day drop in over a month (Updates with price action in southern Europe, adds comment, chart, bullets)

LONDON, May 5 (Reuters) - The euro, southern government bonds and European stocks lost ground on Tuesday after Germany’s top court ruled that the Bundesbank must stop buying bonds under the European Central Bank’s stimulus scheme if the ECB cannot justify the purchases.

The ruling that Germany’s central bank must end the government bond purchases within three months unless the ECB can prove they are needed clouds the bloc’s monetary policy outlook at a time when the coronavirus is hammering economic growth.

The decision did not apply to the ECB’s PEPP coronavirus pandemic-fighting programme, a 750 billion euro ($812 billion) scheme unveiled in March at the height of a coronavirus-induced financial market rout.

But the ruling raised concern about further expansions in ECB asset purchases. That manifested in a sharp selloff in Italian government bonds, while the euro tumbled more than 0.5%.

“The good news is that the ruling does not seem to apply to the PEPP, but there is a bigger concern that it limits the ability of the ECB to “do whatever it takes,” said Sarah Hewin, chief Europe economist at Standard Chartered.

Amassing nearly 3 trillion euros of bonds since 2015, the ECB has long relied on asset purchases to support the euro zone economy through crises and the threat of deflation.

The euro was down 0.65% at $1.0836 and was set for its biggest daily drop in more than a month. It earlier fell to as low as $1.0826, its lowest in almost a week.

In bond markets, southern Europe bore the brunt of the selling pressure. Italian 10-year bond yields were around 18 basis points higher at 1.94% - pushing the gap over safe-haven German Bund yields to 250 bps, the widest in around 1-1/2 weeks.

Spain’s 10-year bond yield gap over Germany widened to almost 145 bps, up around 8 bps from late Monday levels. Portuguese 10-year yields jumped 7.5 bps to 0.95% .

As the selling pressure in peripheral bonds gathered pace, investors moved back into German bonds, allowing that market to recover from a post court-ruling selloff. The 10-year Bund yield was last down around 2 bps at -0.57%.

“The court ruling highlights that core countries not only face political hurdles to any form of liability sharing but also legal hurdles,” said Richard McGuire, head of rates strategy at Rabobank, explaining the weakness in peripheral bond markets.

ECB policymakers will discuss the ruling at a Governing Council meeting starting at 1600 GMT, a spokesman for the bank said.

Among stocks, the pan-European index cut some of its gains following the ruling and was up 1.5%. Germany’s shares briefly touched day lows, while euro zone banks halved their gains and were up 1.2%.

The Italian banking index cut most of its gains and was up 0.3%.

“The PSPP (long-term bond purchase programme) violates German law but I think the three-month deadline is important to clarify proportionality and the ECB can move on after that. In the meantime PEPP carries on as normal,” said Societe Generale strategist Kenneth Broux.

“It illustrates the difficulties versus the Fed for example; the Fed has no such constraints of U.S. states challenging QE (quantitative easing) there.” ($1 = 0.9234 euros)

Additional reporting by Saikat Chatterjee, Joice Alves, Sujata Rao and Olga Cotaga ; Writing by Dhara Ranasinghe; Editing by Alexander Smith and John Stonestreet