NEW YORK/LONDON, March 4 (Reuters) - The arrest of former Brazilian president Luiz Inacio Lula da Silva fueled a massive market rally but once the euphoria fades, investors will still face concerns about political chaos and an economy mired in a deep recession.
Lula's detention for questioning in a bribery and money laundering probe and the move's dire implications for his protege and successor, President Dilma Rousseff, sent Brazil's benchmark Bovespa index soaring more than 5 percent, bringing its two-day gain to roughly 10 percent.
Rousseff is widely blamed by investors for spending policies that brought a ballooning budget deficit and surging inflation, problems compounded by a political crisis that has gripped the country in the 16 months since she won a hard-fought re-election as the Workers' Party candidate.
The market rally also saw a nearly 4 percent gain in the real currency against the dollar to a six-month high of 3.65, although it later roughly halved those early gains.
Lula's emergence as a target of the probe that began as an examination of kickbacks and inflated contracts at state oil company Petrobras is clearly bad news for Rousseff. Yet it is far from clear it will bring in a more investor friendly government any time soon.
"I don't think this is positive for the market at all in the sense that Lula will likely take the union and leftist movements to the streets in a defensive move," said Jorge Piedrahita, CEO of broker Torino Capital. "This means things will get nastier in Brazil before they get better. I would be selling into this rally."
Brazil suffered a 3.8 percent drop in gross domestic product last year which set the stage for Brazil's deepest recession on record. Latin America's largest economy will not return to its pre-crisis size until 2019, a Reuters poll of economists showed this week.
Maarten-Jan Bakkum, investment strategist for emerging markets at NN Investment Partners in The Hague, said he expected Rousseff "will eventually be impeached but the problem is that until we get there, they have a major fiscal crisis to resolve" - an onerous deficit and rising debt levels.
"A new government may do it but we could be a year away from that," Bakkum said. "That's why I am not buying."
Brazil's markets are notoriously volatile. A sign that the current market rejoicing could just as soon turn again to despair. Even after a 24 percent rally over the past month, the Bovespa is still down 3 percent over the past year.
Petrobras', the state-owned oil company once run by Rousseff, sits at the epicenter of the bribery and money laundering probe which has already implicated some of Brazil's highest profile politicians and business leaders.
The market rally was kicked off on Thursday by a report that ruling party Senator Delcidio Amaral, a major legislative ally of Rousseff before he was arrested in November, had tied the president and Lula to the scandal.
"A month ago the possibility of an impeachment was very low...and all of sudden the game changes," said Pablo Cisilino, a portfolio manager at Stone Harbor, a fixed-income investment management firm. "Anything that leads to a political resolution in Brazil is positive."
Major beneficiaries have included miner Vale, which has also been helped by a bounce back in iron ore prices and the Petrobras scandal, and steelmakers CSN and Usiminas. Vale's preferred shares are up 48 percent in the past week.
All four companies have big chunks of dollar-denominated debt, a burden eased by a stronger real.
Writing by Christian Plumb; Additional reporting by Saqib Iqbal Ahmed and Tariro Mzezewa in New York, Silvio Cascione in Brasilia and Clare Milhench in London; editing by Grant McCool