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The euro briefly touched a seven-week low against the dollar to trade near $1.30 after no clear majority emerged from the vote, raising the prospect of weeks of political uncertainty and potentially another election later in the year.
"This is the worst possible outcome from the market's point of view," said Alessandro Tentori, Citigroup's head of global rates.
Yields on 10-year Italian government bonds jumped 45 basis points to 4.82% while Italy's main stock market index tumbled five% with shares in some of the country's major banks down over 10%.
Other European markets were also slumping, with London's FTSE 100, Paris's CAC-40 and Frankfurt's DAX down as much as 2.5%. The pan-European FTSEurofirst 300 index was down 1.3%.
Italy's centre-left bloc led by Pier Luigi Bersani narrowly won control of the lower house but no party or coalition appeared to be in a position to take a majority in the equally powerful Senate. A party led by the anti-establishment comic Beppe Grillo gained more than 25% of the vote.
"The very close result and the stalemate between the two houses of parliament point to a non-trivial risk of new elections," Holger Schmieding, chief economist at Berenberg Bank, adding there was also a small risk that new elections could lead to a referendum in Italy on the euro.
The euro steadied at around $1.3080, up about 0.15% after falling as low as $1.3039, its lowest since January 10.
The focus will now be on an Italian treasury bill auction later, when Rome's borrowing costs could rise.
Ahead of the auction investors were showing a clear preference for safety, with the yield down 8 basis points at 1.5% on 10-year German bonds, while riskier Spanish and Portuguese bonds were coming under heavy selling pressure.
Elsewhere investors were awaiting testimony later in the day from US Federal Reserve Chairman Ben Bernanke for further clues to when the central bank intends to slow down or stop its bond-buying programme.
Financial markets were rattled last week by minutes of the Fed's January meeting showing some Fed officials were thinking of scaling back its monetary stimulus earlier than expected.
US stock futures were flat to suggest a cautious Wall Street start.
