The prospect of elections as early as September, with the prospect of eurosceptic parties strengthening their position, hit markets.
Italy’s benchmark FTSE MIB sank in morning trade, down 3%. The UK’s FTSE was down 1.37%, Germany’s Dax down 1.85%, and France’s Cac down 2%.
And the sell-off in Italian bonds deepened, with the yield on two-year debt breaking through the 2% barrier.
The yield on the bond is set for its biggest one-day jump in 26 years.
Movements in bond prices are important as they affect the cost of borrowing for the government. Italy’s debt currently stands at 130% of its economic output.
The bond sell-off hit the share price of Italian banks exposed to government debt, with Intesa Sanpaolo, BPER Banca, Unicredit and UBI Banca falling sharply.
Meanwhile the pan-European Stoxx 600 fell 1.6%, with banks the worst-performing shares, and the euro fell against the dollar and pound.
The turmoil was precipitated after the anti-establishment Five Star and League political parties abandoned their attempts to form a ruling coalition after a standoff with President Sergio Mattarella.
He had vetoed their choice of a eurosceptic economy minister, and appointed former International Monetary Fund official Carlo Cottarelli as interim prime minister with the task of trying to form a government.
But his term is likely to be cut short, as he will almost certainly lose a parliamentary vote of confidence. If he does, then new elections would soon follow.
Five Star and the League won 33% and 17% of votes respectively in March’s election, and could increase their combined majority in a new national poll.
“We’ve seen a steep sell-off in risk assets as the Italian political troubles deepen, with investors seemingly dumping their exposure to Italy,” said Neil Wilson, chief analyst for Markets.com
“The moves this morning warrant attention as we are seeing some incredible price action in Italian bonds with the market moving at speeds not seen since the worst of the eurozone debt crisis.
“The big question is whether this is just an Italian problem or one that risks significant spill-over into the rest of Europe.”