Huh...I fixed the problem by changing the x.xkbd file. Each letter use to say this:
<key>
default a
default_ks A
shift A
shift_ks A
obey_capslock yes
width 26
</key>

I changed the default_ks for each letter to be lower-case:
default_ks a

Now everything works as expected. Methinks the s.xkbd file I downloaded from the site was hard-coded for caps.

This is a sweet little app. Does everyone know that sliding up on your stylus will make the letter capitalized? A pity I can't change the Hildon environment to push the windows to the left side so I can just leave xkbd on the right. Thanks for making this!

- Jim