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.
According to Henderson the Cyprus bailout is a "worrying precedent" for future treatment of other troubled euro zone economies. "It's not the size of Cyprus [that is important], it's what it represents and undoubtedly depositors across the area, particularly the periphery, are going to take note. Will we see a bank run? No, but we could see a slow bleeding of deposits out of Southern Europe," he added.
Ilya Spivak of online forex trading broker, FXCM added, "In Greece, the issue was never about the nation specifically but about the precedent that Greece could set as the first country feared to exit the euro zone. That's the danger for Cyprus, it's the danger of precedent."
Will the Next Euro Scare Be Worse?
While markets in Asia recovered lost ground on Tuesday - putting to rest fears that the reaction to the Cyprus bailout chaos could have been worse - some analysts warn the next euro zone shock has the potential to be worse.
According to Jason Hughes, market strategist at trading firm IG Singapore, the Cyprus bailout has put investors on edge, and reaction to another euro zone shock, such as further uncertainty in the Italian political situation, could now be more pronounced.
"This does mean if Spain or Italy get close to asking for a bailout again, we could see more pressure on the bond markets, and we could see depositors withdrawing their savings at an earlier stage than we would have seen," he added.
(Read More: Cyprus Bank Levy Unlikely to Pass Parliament)
However, other analysts argue the risks from the Cyprus bailout should not be overstated.
"It certainly does have the potential to undo the positive euro zone sentiment we have seen over the past six months and we have seen that reaction in Asian trading yesterday [Monday]. The danger is in overstating that risk, however," said Shane Oliver, head of investment strategy at investment house AMP Capital.
(Read More: Why ECB's Draghi Faces a Bond Market Dilemma)
"Draghi's words are still there. If this had happened two years ago we would have seen bond yields in Italy and Spain, and even France, shoot higher," he said. "But the situation is different now."
European political leaders have made significant progress following Draghi's statement last July, including the setting up of the formal bailout fund to provide assistance for troubled euro zone peripheral economies. The European Central Bank has also since then come up with an extensive government bond-buying program designed to cut debt levels of struggling countries.