Asian stocks retreated on Tuesday, following Shanghai shares into the red and keeping nerves frayed about whether further profit taking will end the bull market that emerged from the financial crisis.

The Shanghai composite index <.SSEC> fell 1.1 percent to a two-month low, after suffering its biggest single-day drop in nine months on Monday. Fears that China is slowly winding down easy money policies are haunting investors.

The drop in China's market had a domino effect on other markets, fueling worries that rallying asset prices have run too far ahead of economic fundamentals and weak earnings prospects.

U.S. equity futures gave up early gains and traded roughly flat, reflecting the jolt to investor confidence.

However, one of the main drivers of the equity rally in Asia, piles of money that monetary authorities pumped into banking systems, may still have a supportive effect in coming weeks, even with asset prices extended.

History tells us when markets rise as much as they did in the second quarter, they should come down. It's hard to say where the floor is, but I don't think it's far from where we are now, said Mark Matthews, Asia Pacific strategist with Fox-Pitt Kelton in Hong Kong.

This is a liquidity-driven bull market. It's not a market being driven by valuations.

The MSCI index of Asia Pacific stocks traded outside Japan slipped 0.8 percent after tumbling 3.7 percent on Monday, the biggest daily decline since March 30.

But the index is still up 67 percent since March 9, when a global equity rally began and signaled a marked improvement in investors' comfort with taking risks for bigger returns.

Volatility in Shanghai dragged Hong Kong's Hang Seng Index <.HSI> down 0.4 percent.

Japan's Nikkei share average <.N225> also surrendered early gains as China shares sank, and ended the morning down 0.8 percent.

EVERBRIGHT SOARS

Pressured by worries that the global economy may take longer than expected to recover, and disheartened by mounting losses in Shanghai, U.S. stocks posted their biggest one-day fall in seven weeks on Monday, with profit taking also hitting commodities. <.N>

I think macroeconomic indicators in general suggest that things are improving globally and there's no reason to be so pessimistic, but there's not a lot we can do about market sentiment as long as stocks keep on falling, said Noritsugu Hirakawa, a strategist at Okasan Securities in Tokyo.

Profit taking has knocked down the Shanghai index down around 18 percent in the last two weeks after it jumped more than 90 percent since the start of the year.

But the IPO boom in China gained pace, even if broader investor demand was cooling. Shares of China brokerage Everbright Securities Co <601788.SS> rose as much as 42 percent in their debut in Shanghai before slightly paring early gains.

The tight relationship that the Australian dollar had had with equities loosened some, with the currency up 0.3 percent to US$0.8230 after minutes from the Reserve Bank of Australia meeting underscored that policy would be tightened as a recovery took hold.

The U.S. dollar and the yen both retained broad gains on uncertainty over the strength of a global economic recovery.

The ICE Futures U.S. dollar index <.DXY>, which tracks the dollar's value against a basket of six currencies, was largely unchanged, not far from a two-week peak of 79.514 hit on Monday.

U.S. crude oil futures also steadied, rising 0.2 percent to $66.88 a barrel after falling to a two-week low on Monday. (Additional reporting by Elaine Lies in TOKYO)

(Editing by Kim Coghill)

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