AI worries expose dollar's hot-money problem

By Karen Brettell

Oct 28 (Reuters) - Investors have long treated the US dollar as a refuge when markets fall, but foreign money chasing returns from the AI boom could weaken that safe-haven role if the trade unwinds.

Foreign capital has poured in to US mega-cap equities, hyperscaler corporate bonds and power-grid infrastructure. That has made the dollar an increasingly crowded bet on American exceptionalism, backed by faster growth, higher yields and persistent foreign demand for US assets.

But if the AI narrative stumbles, the dollar's safe-haven status could collide with its growing role as a risk-sensitive asset owned increasingly by price-sensitive investors. A sustained selloff in stocks could lead investors to sell US assets, potentially drowning out the safe-haven demand for the currency.

If the AI trade unwinds, "it's not as clear the dollar benefits in the same way it would have done in the past," said Dominic Bunning, head of G10 FX strategy at Nomura.

STORM WARNING ON FOREX FLOWS

Last week offered an early warning. When AI valuations came under pressure, haven flows favored the Japanese yen and Swiss franc over the dollar. The greenback managed to eke out modest gains against the euro, mainly due to the single currency being dented by concerns over French civil unrest.

"The relationship between the AI trade and the dollar has become much more visible when the AI trade comes under scrutiny," said Kevin Ford, lead FX and macro strategist at Convera.

Foreign flows into US equities are at a record, while foreign direct investment has lagged. As a result, much of the capital is coming from institutional allocators that may buy or sell when they reassess US growth, rates, or tech valuations.

Erik Nelson, global head of FX strategy at Wells Fargo, likens these allocations to the "hot money" flows that dominate emerging markets. The AI boom has reinforced expectations of stronger US growth, firmer inflation and higher rates, lifting the dollar alongside Treasury yields, analysts said.

"The whole AI trade caused US rates to reprice higher, which has caused the dollar to rally," said Noah Buffam, FX strategist at CIBC Capital Markets.

If returns disappoint, an unwind could hit equities, credit and rates, leaving the dollar vulnerable on three fronts.

Weaker growth could force the Federal Reserve to cut rates, eroding the dollar's yield advantage. Slower domestic investment would puncture the exceptionalism narrative. And fading institutional demand for US corporate bonds and equities would weaken a major source of structural support.

So far, investors have been willing to buy dips, suggesting that any sustained weakness could be a process taking months or years.

THE DOTCOM LESSON

An equity rout alone would not automatically sink the dollar, Nelson said. After the Nasdaq peaked in March 2000, the dollar stayed firm for nearly two years before cracking when US credit markets came under stress following collapses such as WorldCom's, and due to other factors such as a recovery in global growth.

But the AI buildout is more US-centric. Nelson said the real trade-weighted dollar has stayed above its long-run average, measured since 1973, for 12 consecutive years, the longest stretch on record. Foreign inflows are also more concentrated in equities and corporate bonds than in 2000, while foreign direct investment is weaker.

If infrastructure investments fail to pay off, credit spreads could widen, forcing AI companies to curb capital spending. That could ripple through the economy, softening demand for industrial equipment, hardware and energy.

Concerns about riskier parts of the AI universe, such as heavily indebted neocloud companies including CoreWeave, have already widened credit default swap spreads sharply in recent weeks, adding to pressure on stocks.

"We can see this fraying around the edges when we look at credit default swaps," said Shaun Osborne, chief FX strategist at Scotiabank.

Washington also runs a large fiscal deficit now, compared with a surplus near the 2000 tech peak. That leaves less room for counter-cyclical stimulus without unsettling debt markets.

SENSITIVITY UNDER STRESS

For Nelson, the key signal is not simply whether US tech shares fall, but whether stress becomes a US-specific credit and growth problem that can also change expectations for Fed policy. In such a scenario the yen would likely benefit at the dollar's expense, a shift that could have further ramifications for markets that would already likely be under stress.

That is not to say a dollar decline is a foregone conclusion. A shock severe enough to trigger a scramble for dollar funding could initially strengthen the dollar. In 2008 and March 2020, investors rushed to obtain dollars to meet dollar-denominated liabilities, creating a powerful but temporary bid.

In any case, some investors believe the dollar is back on the table as a major risk factor in the most significant way since the rout caused by US President Donald Trump's announcement of sweeping tariffs in April 2025.

"The sensitivity of global investors to a large re-rating or selloff in the dollar is substantial," Nelson said. "As we go into '27, it's a vulnerability for the dollar that I think is worth watching.”

(Reporting by Karen Brettell in New York; Editing by Colin Barr and Matthew Lewis)