The Liquidity Rally – theory
Liquidity 
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A pegged currency that is allowed to float freely usually falls sharply for at least the first six months after the free float is put in place, overshooting any idea of fair value. The rule is the longer a central bank tries to defend it, the further the currency falls in the end. Currency market participants who earlier dismissed the idea of currency risk have to chase the market to put belated hedges in place. In addition, at the macroeconomic level inflation rises as the pass-through effect to the real economy of maxi-devaluation. The signal that the devaluation is at an end is when that inflation rate peaks. At that time, portfolio money starts to flow back into the country, attracted by high nominal interest rates. This in turn allows the local currency to recover potentially significant ground. In line with this, the trade account improves significantly as import demand collapses in the wake of economic contraction. Thus a liquidity-based rally in local asset markets and the local currency is created through lower interest rates and renewed portfolio inflows. This is different from Phase IV, which sees a fundamentally-based rally, as demand-side indicators continue to deteriorate during this period.
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