The Milan stock exchange plunged more than three percent Tuesday, while Italy's debt-risk premium surged, reflecting investor worry over the prospect of a fresh eurozone crisis.
Financial markets are nervous as Italy faces the prospect of new elections as early as September after a nascent populist government collapsed over the weekend, prolonging almost three months of uncertainty.
At close on Monday, Italy's 10-year bond yields were 235 basis points higher than Germany's, already their top levels since 2013, before surging further to over 300 basis points Tuesday morning.
Yields typically rise at times of stress as investors demand higher returns if they are to buy a country's bonds.
Italy was waiting Tuesday for caretaker prime minister and former IMF economist Carlo Cottarelli to assemble a cabinet lineup for a technocrat government after a bid for power by an alliance of anti-establishment and far-right parties failed to get off the ground over the weekend.
President Sergio Mattarella vetoed the alliance's pick for economy minister, fierce eurosceptic Paolo Savona, throwing the eurozone's third largest economy into a fresh crisis.
For Cottarelli to form a government, parliament must endorse his team -- something the nationalist League party and the Five Star Movement who hold a majority in both houses have staunchly refused to do.
In the absence of a confidence vote Italy could return to the polls as early as September.
Investor worries are particularly high because there are concerns that the Five Star Movement and the League could win even more votes if a fresh vote is held.
"The risk here is that a re-election will lead to a stronger populist group forming, and thus, a possible referendum on the European Union," wrote Hussein Sayed, chief market strategist at FXTM.
"This will eventually lead to further rating downgrades from credit rating agencies, and with outstanding debt of more than 2.3 trillion Euros, Italy's public finances will look to be in a very bad shape."