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.
The euro sank, losing 0.7 percent Tuesday to $1.1540, and investors dumped Italian bonds while seeking safety in U.S. Treasurys and German bunds. The 2-year Italian yield briefly snapped above 2.73 percent, a sharp move from just 0.48 percent on Friday and a negative yield earlier this month.
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."
But Rupkey also said the markets are reacting to news that occurred over a three-day holiday weekend in the U.S. and may not be as turbulent in upcoming sessions. "It's not a full-blown European sovereign debt crisis yet. For one thing, the Italian 10-year yield is a little over 3 percent. Back in 2012, it was at 8 percent. It's not the same situation yet."
"I'm sure many American traders wish that Europe, in general, would stop having these mini referendums on whether the euro is going to survive," said Rupkey. "It's going to be really dragged out. I don't think we can trade on this every day. I don't think 10-year yields in Italy are going to go higher and higher every day, waiting for that vote. The focus is going to shift back pretty quickly to the U.S., which is employment and wage data on Friday."
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.
"The chaos in Europe is pushing down U.S. interest rates so money is flowing to the U.S., fleeing Europe, making people think, that [with falling interest rates], coupled with the rising dollar, that the Fed responds by maybe having second thoughts about the trajectory of Fed policy," said Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman. "It also is a risk to the real economy because Europe's a big trading partner."
The Federal Reserve, driven by a stronger U.S. economy, is on track to raise interest rates for a second time this year at its meeting June 13. The Fed has forecast three hikes for this year, but the markets had been expecting an added hike in September, in addition to December.
"The Fed is going to raise in June, raise in September and then they're going to play it by ear," said Peter Boockvar, CIO at Bleakley Advisory Group.
The U.S. 2-year Treasury yield, the most sensitive to Fed rate hikes, slipped to 2.38 percent, after touching 2.60 percent recently. The 10-year dipped to 2.82 percent from 3.12 percent just several weeks ago.
Chandler said he does not expect a new Italian government to push to exit the euro, though it could threaten other measures. Italy is the biggest debtor in the euro zone, with 2.3 trillion euros in debt, or 132 percent of GDP last year. That is double Germany's level and well above the 87 percent of the euro zone.
"Their tactics would be to make some demands like: 'Let's cut taxes. Let's use our t-bills to pay down our arrears. ... Let's keep challenging the EU,'" Chandler said. "That's the back door to leave. You place demands on the EU."