On October 20, the executive office of the government of Brazil enacted an emergency measure, calling for a 2% tax on on all foreign capital inflows. And with one foul swoop, this year’s 35% rise in the Real had come to an end, right?

The tax certainly took investors by surprise, with the Brazilian stock market falling by 3% and the Real falling by 2%, the largest margins for both in several months. The tax is comprehensive and applies to essentially to all foreign capital deployed in Brazilian capital markets, whether fixed income, equities, or currencies. While the tax doesn’t apply to those currently invested in Brazil, the possibility that it would cause potential investors to stay away was enough to cause a sell-off.

The ostensible reason for the tax levy is to prevent a further rise in the Real. By most measures, the currency’s rise has been excessive, more than erasing the losses incurred during the credit crisis. The concern is that a more expensive currency will derail the Brazilian economic recovery before it has a chance to firmly get off the ground. “Brazil’s currency needs to weaken as much as 19 percent for sustainable economic growth, said Nelson Barbosa, the Brazilian Finance Ministry’s top policy adviser.”

According to cynics, however, the tax is a backhanded effort to raise revenue to fund a growing budget deficit. The government continues to spend money (perhaps to offset the negative impact on exports brought on by the Real’s rise) as part of its stimulus plan, but is increasingly tapping the bond markets to do so. The tax is expected to bring in an impressive $2.3 Billion over the next year, which could go part of the way towards fixing the government’s fiscal problems.

The real question, of course, is how the Real will fare going forward. The initial reaction, as I said, was ‘The Party’s over…‘ But investors with a longer-term horizon aren’t fretting. “In the medium term, the measure will have a limited impact. The fundamentals point to a stronger real, with commodities rising and the dollar weakening globally,” asserted one economist. While investors aren’t happy about paying an arbitrary 2% fee to the government, such pales in comparison to the 10%+ returns that investors still aim to reap from investing in Brazil over the long-term.

Ignoring the possible bubbles forming in Brazilian capital markets (admittedly, a dubious suggestion), Brazil still looks like a good bet, especially on a comparative basis. Interest rate futures point to a benchmark interest rate of 10.3% at this time next year, compared to ~1% in the US. Even after accounting for inflation and the 2% tax levy, the yield spread between Brazil and the US remains impressive. For that reason, the Real has already stalled in its expected fall against the US Dollar, standing only 1.7% below where it was on the day the tax was declared.

It’s unclear how determined the Brazilian government is towards pushing down the Real. The comments by its finance minister suggest that the consensus is that it is not slightly – but extremely overvalued. Thus, it’s likely that the government will enact other aggressive measures to prevent it at least from rising further. It continues to buy Dollars on the spot market, and is trying to make it easier for Brazilians to take money out of Brazil. It is not yet ready to tamper with its floating currency, but by its own admission, the “government was studying additional measures to regulate the heavy inflow of foreign investments and its impact on the country’s currency.”

There are also implications for other (emerging market) currencies. As I wrote earlier this week (”Central Banks Prop Up Dollar“) a number of Central Banks have already intervened or are currently mulling intervention in forex markets, to push down their currencies. You can be sure that other governments will be studying the situation in Brazil closely, with the possibility of implementing such policies themselves.

Over the last week, the markets have been abuzz with chatter about how the US recession will soon come to and end, followed by a quick and healthy recovery. According to investor logic, the result would be a rise in inflation and interest rates. This optimism was partially deflated today, as the Federal Reserve bank conducted its annual monetary policy meeting.

Excluding a brief uptick in June (see chart below courtesy of the Cleveland Fed), investors had long come to expect that the Fed would leave its benchmark Federal Funds rate unchanged, at 0-.25%. At the same time, there was a strong belief that the Fed would begin to hike rates at the end of 2009, and comment accordingly in the press release that accompanied its monetary policy decision. Barron’s predicted yesterday: “The statement will acknowledge some improvement in the U.S. economy, though it will imply that this nascent growth reflected in recent gross domestic product reports is fragile and will be monitored closely. This will leave open the specter that interest rates could be increased at some point in the future.”

Sure enough, the Fed left rates unchanged, and its press release conveyed a restrained sense of hope that the worst of the recession is now behind us: “Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks…Although economic activity is likely to remain weak for a time, the Committee continues to anticipate…a gradual resumption of sustainable economic growth in a context of price stability.” The Fed also announced that its Treasury buying activities would soon come to an end, although it may continue to buy mortgage securities as part of its quantitative easing program.

Perhaps the tone of the press release was slightly less positive than investors would have liked, since interest rate futures dived immediately on the news. Especially compared to last week, investors are now assuming that it will be a while before the Fed actually hike rates: “At Wednesday’s settlement price of 99.655, the February fed-funds futures contract priced in about a 38% chance for a 0.5% funds rate after the late-January meeting. That’s down sharply from about a 60% chance at Tuesday’s settlement, about a 76% chance at Monday’s settlement, and about a 96% chance at last Friday’s settlement.” Analysis of options trading activity reveals that the large brokerage houses believe similarly.

As for the Dollar, it now seems possible that last week’s rally was premature. If the Fed isn’t prepared to hike rates anytime soon, then the current interest rate differentials between the US and the rest of the world will remain intact. More importantly, the Dollar will remain a viable funding currency for carry trades, and the shift of funds into higher-yielding alternatives will probably continue for the time being.