The handling of the Cyprus bailout threatens to derail all the hard work that has gone into boosting sentiment in the euro zone following jitters over Greece, Spain and Italy last year, said analysts.
In July, against a backdrop of surging Spanish debt yields and fears that the euro zone was on the verge of a break-up, the European Central Bank President Mario Draghi pledged to do "whatever it takes" to save the euro, which helped restore confidence.
However, news of a European Union deal for Cyprus that asks bank depositors to contribute towards a bailout by paying a levy, prompted panic over a contagion risk to the rest of Europe.
"This is a hit to confidence and this could be the first of potential further measures down the road," Callum Henderson, global head of forex research at Standard Chartered Bank said.
(Watch This: Cyprus Could Spark 'Slow Bleeding' of Deposits)
Global markets, which have been on a bull run since the start of the year, reacted negatively to the bailout news. In Asia, Japan's benchmark Nikkei, which has risen 20 percent since the start of the year fell nearly 3 percent on Monday while European and U.S. markets ended the day roughly 0.5 percent down.
Earlier this month, the Dow Jones Industrial Average had logged an all-time high, while the German and French stock markets had hit 52-week peaks. The euro which has climbed more than 7 percent since July last year, fell around 1.5 percent against the U.S. dollar on Monday.
Many analysts had expected a looming correction in equity markets and the euro, and the Cyprus bailout deal is now being seen as the potential catalyst for a risk-off phase.