Fears over Italy returned with a vengeance Tuesday, perhaps surprising U.S. investors returning from a three-day Memorial Day weekend as headlines out of Rome sent shock waves through global markets and contributed to a selloff for Wall Street stocks.

See:Here’s why markets are worried about Italian politics — again

Market participants don’t need a long memory to recall the worst days of the eurozone debt crisis in 2011 and 2012, when fears centered on Italy’s massive debt pile, teetering European banks and sluggish growth took center stage. Those worries were effectively pushed into the background in 2012 by the European Central Bank, but they weren’t resolved. And now they’ve resurfaced, at least temporarily, with a political twist.

Read:5 things investors must watch as Italy turmoil shakes global markets

“The pendulum of sentiment has swung from extreme complacency to hints of the paranoia that we saw back in 2011-2012. In the space of roughly under a week the view of the eurozone has changed dramatically,” said Nicholas Spiro, partner at London-based Lauressa Advisors, in a phone interview.

U.S. stocks ended sharply lower Tuesday, after joining a global equity selloff, leaving the Dow Jones Industrial Average DJIA, -1.92% down nearly 400 points, while the S&P 500 SPX, -2.37% dropped 1.2%. The euro EURUSD, -0.07% slid to a six-month low, while European stocks ended sharply lower, with Italy’s FTSE MIB I945, +0.18% ending 2.7% lower, building on the previous week’s sharp losses.

Ground zero was in the Italian bond market, with the 2-year yield TMBMKIT-02Y, -0.226% soaring 157 basis points, or 1.57 percentage points, to 2.41%, while the 10-year yield TMBMKIT-10Y, 0.855% jumped 41 basis points to 3.095%.

Read:Italian stocks, bonds are biggest losers of political unrest in Rome

Here’s a look at what is putting Italy and the euro back in focus.

Italian politics

A March election failed to produce a conclusive result, leading to weeks of jockeying. Over the weekend, the anti-establishment 5 Start Movement and far-right League, a pair of euroskeptic parties who had agreed to work together, were on the verge of forming a coalition government. But Italy President Sergio Mattarella squelched the choice of a euroskeptic economy minister, appointing a new prime minister who isn’t expected to garner the parliamentary support needed to form a lasting government. That means a new round of elections could be in play this summer or autumn.

Opinion:Why Italy’s crisis could be a buying opportunity for stock investors

Investors fear that election could see the anti-establishment parties, which had backed away from outright euroskeptic rhetoric in the run-up to the March vote, adopt more strident positions, potentially turning the vote into a de facto referendum on the country’s euro membership.

Italy is the linchpin

While the region’s debt crisis, which began in 2010, spread from Greece to other countries, Italy, with the world’s fourth-largest government bond market and the eurozone’s third-largest economy, was long viewed by market participants as too big to rescue. An Italian implosion was, therefore, viewed as an existential threat to the euro in a way that Greece and other, smaller financially stressed eurozone countries were not.

Check out:Bank shares pummeled as Italy’s political turmoil sparks government bond selloff

European Central Bank President Mario Draghi was credited with stemming the crisis in July 2012, when he declared the institution would do “whatever it takes” to preserve the euro. This was followed by the formulation of the Outright Monetary Transactions, or OMT, program, which would allow the ECB to buy a country’s bonds in the secondary market to reduce borrowing costs.

Read:4 ways the ECB is helping to prevent an Italian rerun of the euro crisis — for now

It worked. Without the ECB actually tapping the program, Italian borrowing came down from unsustainable levels, with the 2-year yield TMBMKIT-02Y, -0.226% retreating from a level above 7.5%. Later, the ECB’s separate eurozone bond-buying program, the centerpiece of its quantitative easing strategy, pulled yields across the eurozone sharply lower.

While Italian bond yields have jumped over the past two weeks, they remain far off crisis levels. In the event of a prolonged meltdown, the ECB could move to implement the OMT program, but there’s one big problem.

To do so, a government must request help and also agree to abide by a fiscal plan approved by eurozone authorities — something a future euroskeptic government would be loath to do. That’s what it means to say the situation has threatened to become a political, rather than a financial, crisis.

Unfinished work

Meanwhile, European authorities have taken steps to create a more unified currency bloc, including more uniform supervision of banks and tighter fiscal rules. But the measures are seen as falling well short of what’s needed to fix the inherent flaws of the euro, which has no shared fiscal authority.

While 5 Star Movement and the League played down previous euroskeptic rhetoric, they railed against the European Union’s fiscal rules and had appeared headed for a confrontation with Brussels over their own spending plans, which had helped to trigger the initial selloff in Italian debt.

Contagion?

So far, the impact on other eurozone government bond markets has been limited, indicating that investors are fairly confident the region can withstand political uncertainty in Italy, said Stephen Brown, European economist at Capital Economics.

But a lasting crisis in Italy would be unlikely to remain an isolated incident, he said, in a note, arguing that if an outright referendum on euro membership was called, “it would pose a systemic and existential risk to the whole project,” likely forcing the ECB to act.

Now what?

In the near term, investors will be glued to the events in Italy, including any election timetable and the stance on the euro adopted by the main political parties. Moreover, polling in the run-up to an election could be a driver of sentiment, said Bill Adams, senior international economist at PNC.

Overall, the situation serves as a reminder that political risk in the euro area hasn’t gone away, but shouldn’t prompt investors to press the panic button, he said in a phone interview.

“Italy is not on an irrevocable road to anything at this point,” he said. “I think what is most likely is another election later this year, and what we’ve learned is that outcomes of elections are very unpredictable.”