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Artificial intelligence is this year's investment craze and experts say the profit potential is huge, but this period could be transformed by a messy pop la the dot-com bust if the Federal Reserve makes one particular mistake, says Bank of America.

AI is in a "baby bubble" for now, Michael Hartnett, chief investment strategist at Bank of America Global Research, wrote on Friday.

Excitement over AI prospects is palpable in the markets, ignited by the popularity of ChatGPT, OpenAI's open-language chatbot. Among high-flyers, shares of Meta Platforms and microchip maker Nvidia have more than doubled this year. AI tools bolstering advertising at Facebook's parent company are catching attention. Billionaire investors are making big AI bets, including Bill Ackman's push of $1 billion into Google parent Alphabet.

Bubbles, whether they're in the "right things" such as the internet or the "wrong things" like housing, are always started by easy money and are ended by rate hikes, Hartnett said.

The Fed may be on the way to pausing its run of rate hikes at its June 14 gathering. This month, it bumped up its benchmark rate for the 10th consecutive time to beat down inflationary pressures.

But a pause would be a policy error, and the Fed attempting to fix it by restarting rate hikes could burst the AI bubble, Hartnett said, recalling similar conditions in the dot-com era.

The Fed mistakenly pausing in 2023 would be communicated to investors by US bond yields rising above 4%.

"[And] if so we most certainly ain't seen the last Fed rate hike of the cycle," Hartnett said in BofA's Flow Show note.The 10-year Treasury yield was at 3.67% on Friday.

If the Fed were to pause, it would do so as the Consumer Price Index and other inflation gauges have come off peak levels, but as they still sit much higher than the Fed's 2% target rate. The CPI rose 4.9% in April.

With credit conditions tightening, the "policy rate may not need to rise as much as it would have otherwise to achieve our goals," Powell said at a Friday conference in Washington in conversation with former Fed Chair Ben Bernanke. The Fed funds rate was raised to 5%-5.25% in March.

Dot-com bomb

BofA's investment strategy team recalled the frenzy surrounding internet stocks in 1999 that drove the Nasdaq Composite up to new highs at 5,000.

The speculative surge in internet stocks alongside a bubbling US economy forced the Fed under Alan Greenspan to restart monetary tightening, it said. The dot-com bubble popped nine months later.

"AI = internet," wrote Hartnett. The Nasdaq sank 78% from its March 2000 peak until early October 2002. It would take nearly another 15 years for the index to reclaim the 5,000 mark.

Markets for now seem not to be putting much stock in the bubble talk, and hype in the sector is still strong.

AI technology's potential to boost productivity could lead to an increase of 30% or more in S&P 500 profits over the next decade, Goldman Sachs senior strategist Ben Snider told CNBC recently, and AI exposure among large-cap tech companies has helped propel the Nasdaq Composite up 21% so far in 2023 following last year's tumble of 33%.

Fundstrat this week said that investors are right to be optimistic about AI but mega-cap tech stocks currently look overbought.

Traders in the fed funds futures market as of Friday saw an 80% chance that the central bank will halt its run of rate hikes in June.

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AI is in a 'baby bubble.' Here's what could burst it. - Markets Insider