- Stocks sold off and investors ran to safety in Treasurys and the U.S. dollar, as investors feared political uncertainty in Italy could spill into the global economy.
- Strategists said the turbulence and concerns about Italy may be enough to slow down Federal Reserve's rate hikes this year, despite an improved U.S. economy.
- Italy's president over the weekend stopped the formation of a coalition government that may have sought to leave the euro.
Political uncertainty in Italy has unhinged world markets, raising the specter of a euro crisis that could ripple across the global economy and even force the Federal Reserve to slow its rate-hiking plans.
Several strategists say there is little chance the euro zone's third-largest economy will move to leave the single currency, creating a continent-wide crisis of confidence. But internal chaos and a new election could make for a rocky summer for markets and even put a dent in European economic growth.
Italy moved to the foreground as the latest source of angst for markets, after a weekend of drama in which President Sergio Mattarella on Sunday blocked the formation of a government that would have been decidedly against the euro.
The anti-establishment 5-Star Movement, Italy's biggest party, and the far-right League party picked euro critic Paolo Savona as their economy minister. The two parties, both critical of Europe's single currency, had won more than half the votes in March's parliamentary elections. Mattarella vetoed the choice and instead asked Carlo Cottarelli, a former IMF official,toform a temporary government, but both parties object to him, and a new vote is now expected in late July.
Global equity markets slumped, with the Dow tumbling more than 450 points. Banks led the selloff, and the S&P financial sector declined more than 3 percent. In Europe, yields on Italian bank debt spiked as bank shares sold off.
Chris Rupkey, chief financial economist at MUFG Union Bank, said a rash of recent data has already raised concerns about European growth. "This could be the straw that breaks the camel's back in the case of prospects for Europe. It will spill over into the U.S. They won't buy as many of our imports," he said.
"When world economic growth has been threatened in the last three years, it was a concern. It hurts confidence on the economic outlook for the U.S.," he said. "Given what we know right now, I would not be comfortable rushing out and forecasting a rate hike in September."
For some traders, the Italian political crisis is deja vu to the Greek debt crisis, which wound down three years ago after fanning fears that the whole financial and economic fabric of the euro zone could unravel.
Spain is another worry for markets, with a vote of confidence later this week on the administration of Prime Minister Mariano Rajoy because of a campaign finance scandal. That could force a new election for that country, which has already seen a deep divide over the Catalan region's wish to split from Spain.
- "If you just look at the economic fundamentals of Italy, they are worrying," Mouhammed Choukeir, chief investment officer at private bank Kleinwort Hambros, told CNBC's "Squawk Box Europe" Tuesday.
- Italy's 10-year yield surged another 50 basis points by 11.00 a.m. London time. A bond yield moves inversely to the price.
- Spain, specifically, is facing a confidence vote this week for its leader Mariano Rajoy.
The contagion risks from a potential Italian implosion should concern market participants once again, according to analysts.
The euro zone's third-largest economy is currently in the midst of an ongoing power struggle, with investors fearful the looming prospect of snap elections could be fought over the country's role in the European Union and its membership of the single currency.
Rome's deepening political crisis has prompted a second consecutive session of heavy selling in European financial markets Tuesday, with stocks tumbling and the euro slipping to fresh six-month lows.
"If you just look at the economic fundamentals of Italy, they are worrying," Mouhammed Choukeir, chief investment officer at private bank Kleinwort Hambros, told CNBC's "Squawk Box Europe" Tuesday.
"It is one of the biggest indebted countries in the world … it's got an unemployment rate of 11 percent and its economy is still lower than where it was in 2007, whereas most major economies have recovered. So, clearly there is a requirement for structural reform here in order to regain confidence," he said.
"(Last year) was a stellar year for economic growth in Europe, we've seen a resumption of inflation so those deflationary fears went away and it almost happened in a flash … Now everybody is concerned about potential for deflation and even potential for contagion," he added.
Usually associated with a financial meltdown, contagion refers to the spread of market disturbances from one region to others.
Among national indexes, Italy's FTSE MIB slumped over 2.5 percent during mid-morning trade Tuesday, while Europe's banking index fell to 13-month lows amid a steep sell-off in Italian government bonds. The index was on track to register its worst daily loss in 21 months, while excessive losses forced some lenders to halt trading.
Investors fear a deeply divisive election campaign could deliver a euroskeptic government prepared to break up the bloc. The renewed concerns over the future of the European Union prompted Sentix's euro zone break-up index to climb to its highest level since April 2017 — when France's Marine Le Pen campaigned for the presidency.
Italy has been without a government since an inconclusive vote in early March, with anti-establishment political groups abandoning their efforts to form a coalition over the weekend amid a dispute with the country's head of state.
President Sergio Mattarella, who was installed by a previous pro-EU government, refused to accept the nomination of euroskeptic candidate Paolo Savona for economy minister on Sunday.
Instead, he set the country on a path to another snap vote by appointing former International Monetary Fund (IMF) official Carlo Cottarelli as interim prime minister. Cottarelli, who became known as "Mr. Scissors" for his reputation regarding cuts to public spending in Italy, is now tasked with the planning of fresh elections and passing the next budget.