It is difficult, if not foolish, to call the end of a strong trend, especially as strong of a trend the Japanese yen has experienced over the past eight months. In less than six months, the yen has been the strongest currency when compared to major world currencies, strengthening from 23% against the U.S. dollar to more than 60% against the New Zealand dollar. With such positive yen movement, planning for a reversal needs to be done in a precise, analytical way. The analytics I'm referring to are fundamental and technical reasoning for a trend reversal.

Beginning with the fundamentals, knowing why the yen has strengthened can help determine when its strengthening is over. During the past few years, volatility changes have driven the yen. It gains strength when volatility rises and weakens when volatility drops. It also has a history of being part of the "carry trade" in which banks and institutions sell it at a very low rate (between 0.0% and 0.5% over the past five years) and buy higher interest currencies to capitalize on the differential of interest rates in a leveraged market. Many analysts accredit the carry trade for the volatility correlation with the yen. As volatility rises, institutions are less likely to take higher risk or leveraged trades. The carry trade, though a profitable methodology, is considered higher risk due to the leverage. As volatility has risen over the past year, short yen positions have been covered, driving demand for the yen up. Basing sentiment for the yen on volatility alone, using the VIX as our volatility indicator, volatility has fallen from a peak of more than 80 in October to near 40 this week, creating a bearish sentiment.

In addition to lower volatility, the Japanese economy has struggled significantly. Japanese gross domestic product (GDP) has fallen four quarters in a row and economic growth has constricted to an annualized rate of -12.7%, the worst GDP rate since 1974. Institutional tracking, derived from the Commitment of Traders Report (COT), indicates similar bearish sentiment as yen positions are currently net short on 60,000 contracts. Price has diverged significantly from institutional selling.

The most dramatically oversold currency in the past year has been the New Zealand dollar. The New Zealand dollar is highly correlated to commodities and is currently the highest interest-yielding currency of the major world currencies. A long trade on the NZD/JPY is bullish on commodities, favors the carry trade, and is bearish on the yen and struggling Japanese economy.

Considering price action and technical analysis of the NZD/JPY pair, the commodity channel index has created a bullish divergence at a multi-year low and support (see Figure 1). Additional confirmation can be obtained if price action breaks through the trend line. A break above the trend line may also be considered a trend reversal.

Figure 1 -- Potential Bullish Divergence between Price and Commodity Channel Index

Although Figure 1 is a chart of the NZD/JPY spot currency pair, a similar trade can be created by trading CME futures. This can be accomplished by buying or going long on the New Zealand dollar future (NEM9 for the June Future) and selling or going short on the Yen Futures (JYM9 for the June Future). Because of the similarity and correlation between the Australian and New Zealand dollars, a similar scenario can be seen on the AUD/JPY pair, which can then be traded with one long CME aussie dollar/ Japanese yen Future (AJM9 for the June Future). This analysis is for a potential trend reversal and not for risk management or timing. Be sure to use good risk management in all trade opportunities.

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