Asian stocks and commodities retreated on Tuesday as wary investors took profits from a rally ignited by China's weekend decision to give its currency more flexibility.

European shares were expected to follow Asian and U.S. stock markets into the red, with Britain's FTSE 100 <.FTSE>, Germany's DAX <.GDAXI> and France's CAC-40 <.FCHI> seen opening as much as 1 percent lower.

In addition to concerns about China, financial markets turned cautious ahead of Britain's budget later in the day, which is expected to contain massive spending cuts and tax rises as worries about sovereign debt levels spread throughout Europe.

China's currency reforms initially sparked a global rally in riskier assets on Monday on hopes that a stronger yuan would boost its already formidable purchasing power for imported goods and raw materials, giving the global economic recovery a much-needed shot in the arm.

But that euphoria quickly vanished as investors took a more considered view of the impact the move would have on China's actual near-term demand and grew skeptical about how much Beijing would allow the yuan to rise.

Big Chinese state-owned banks kept the yuan in check on Tuesday, a day after its biggest rise since the currency was revalued in 2005, indicating Beijing will allow the currency to appreciate at a far slower pace than demanded by its critics in the West.

Japan's Nikkei <.N225> slipped 1.2 percent as foreign investors turned sellers after the benchmark powered to a one-month closing high in the previous session.

The MSCI index of Asia Pacific ex-Japan stocks <.MIAPJ0000PUS> fell 1 percent, with losses in technology <.MIAPJIT00PUS> and resources <.MIAPJMT00PUS> sectors providing the main drag. On Monday, the index had bolted 3.2 percent to a five-week high as China allowed the yuan to rise.

I don't believe China is doing this because the world is in fantastic shape and the outlook is exceedingly bright, said Emil Wolter, head of regional strategy at Royal Bank of Scotland.

They are doing it for political reasons, he said referring to a meeting later this week of leaders of the Group of 20 leading industrialized and developing economies in Canada, where global trade imbalances are expected to be a key issue.

Wolter said China's announcement on the yuan was a welcome respite for markets after the worst May in 12 years, which had seen investors take substantial short positions. The size of the gains on Monday may have been amplified as traders scrambled to close out such bets against the market.

Sell in May and go away is an old stock market adage which refers to the seasonal weakness in shares.

Attention will also be focused on whether the U.S. Federal Reserve will reiterate its commitment to keeping interest rates exceptionally low for an extended period at the end of its two-day meeting on Wednesday.

CHINA SYNDROME

China's central bank set the yuan's daily mid-point at 6.7980 against the dollar on Tuesday, the highest level since the yuan's revaluation in July 2005, signaling it could allow the yuan to rise further.

But the move gave markets only a brief respite from early selling pressure as the spot rate soon fell. The yuan rose to as high as 6.7900 in early trade, up 0.11 percent from Monday, when it jumped nearly 0.5 percent. But by afternoon it had slipped 0.35 percent.

Tuesday's fixing initially reignited demand for riskier currency trades, with the Australian dollar and the euro jumping to the day's high against the dollar. But again the rise was short-lived and by afternoon the euro dipped 0.27 percent to $1.2289.

The Australian dollar rose as high as $0.8834, up from around $0.8765 just before the mid-point was announced. The Australian dollar then dipped and by afternoon it was flat.

Investors are growing more cautious on the view that the magnitude of the yuan's new flexibility may not be as big as the market had earlier hoped, said Lee Sun-yeb, a market analyst at Shinhan Investment Corporation in Seoul.

It seems the market is taking a bit of breather following its recent sharp gains, as it nears the earlier highs. Foreign buying has also halted.

Analysts expect more volatility ahead as markets test how much yuan appreciation Beijing is willing to stomach.

The authorities want to say they are showing a more hands off approach and more flexibility in the markets, but the reality is they are introducing more intraday volatility in the market, said Craig Chan, senior FX strategist at Nomura International.

(Additional reporting by Saikat Chatterjee in HONG KONG and Jungyoun Park in SEOUL; Editing by Kim Coghill)

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