European financial market
A picture illustration of of kuna coins laying on kuna and euro banknotes REUTERS/Nikola Solic

A deepening political crisis in Italy provoked the second day of heavy selling on European financial markets, with the euro cut to a 6-1/2 month low, stocks punished and short-term borrowing costs surging for the government in Rome.

Investors fear that repeat elections - which now seem inevitable in the euro zone's third-largest economy - may become a de facto referendum on Italian membership of the currency bloc and the country's role in the European Union.

Short-dated Italian bond yields — one of the most sensitive gauges of political risk — soared as much as 80 basis points to their highest since late 2013 as investors' anxiety deepened.

The euro dropped below the $1.16 line for the first time in 6-1/2 months, down 0.3 percent on the day. Against the Swiss franc, it fell by a similar margin at 1.1528 francs.

Stocks in Milan slid 2.6 percent on the main index after a 2.1 percent fall on Monday. Bank shares slumped another 5 percent, having lost 4 percent in the previous session, bruised by the sell-off in government bonds, a core part of Italian banks' portfolios.

"It is just a slide and as the slide continues, you ask where is the end," said Saxo Bank's head of FX strategy John Hardy. He added that there was a risk of global contagion, with the benchmark U.S. S&P 500 stocks index also close to breaching some key support levels.

Hardy recalled a promise made in 2012 by European Central Bank President Mario Draghi to keep the euro intact.

"If this continues for another couple of sessions I think you will have to see some official (European) response. A 'whatever it takes' kind of moment," he said.

Adding to the uncertainty, Spanish Prime Minister Mariano Rajoy will face a vote of confidence in his leadership on Friday.

Spain's bond-yield spread with Germany was also at its widest in seven months at 122 bps. Madrid's IBEX bourse was down almost 2 percent.

Asia flinched too. Japan's Nikkei slipped 0.6 percent. Chinese shares were in the red, too, with the blue-chip index down 0.6 percent and Hong Kong's Hang Seng index off 0.7 percent.

E-Mini futures for the S&P500 also gave up early gains to be down 0.5 percent. Meanwhile, the dollar was up against almost all major currencies except the safe-haven Japanese yen.

The U.S. currency is heading for its best month in 1-1/2 years - a move that is hurting many emerging market countries that borrow in dollars.

"This should keep the risk trades pressured to the downside," Nick Twidale, a Sydney-based analyst at Rakuten Securities Australia.

Away from Europe, the focus was also on the on-again, off-again U.S.-North Korean summit and the U.S.-China trade relationship.

An aide to North Korean leader Kim Jong Un arrived in Singapore on Monday night, Japanese public broadcaster NHK reported, and the White House said a "pre-advance" team was travelling to the city to meet the North Koreans.

The reports indicate that planning for the summit, initially scheduled for June 12, is moving ahead after President Donald Trump called it off last week. A day later, Trump said he had reconsidered, and officials from both countries were meeting to work out details.

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In another sign that investors were flocking to safer bets, the euro hit an 11-month low versus the yen and fresh 6-1/2 low against the Swiss franc

Elsewhere in bonds, U.S. 10-year Treasury yields were at six-week lows at 2.883 percent after a U.S. holiday on Monday. Yields move inversely to price.

Analysts are awaiting U.S. inflation data later in the week which could provide clues to future interest rate rises ahead of the Federal Reserve policy meeting next month.

Oil prices remained under pressure from expectations that Saudi Arabia and Russia would pump more crude, even as U.S. oil output rises.

U.S. crude futures tumbled to six-week lows and looked set for a fifth straight day of declines. The July contract was last down 1.6 percent at $66.81 a barrel.

Brent crude futures edged up 0.3 percent after dropping to $74.49 per barrel on Monday, their lowest in about three weeks. They were last at $75.53.

Spot gold was barely changed at $1,298.01 an ounce.