When Will the AI Bubble Burst? Watch Credit Default Swaps and Token Prices
The AI bubble will eventually burst, but current valuations are far below dot-com levels, with Nvidia at just 15x earnings. The real risk lies in credit markets, where credit default swaps have risen to historic highs, signaling a possible sharp correction ahead.
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Token prices fell 50% but usage rose 2.5x
Dan Niles points out that to judge whether the AI bubble has peaked, two core variables matter: token output and unit price. Since late May, due to open-source model competition, token unit prices have fallen about 50%, but output has grown 2.5x over the same period. As long as output growth offsets price declines, industry revenue is still expanding. Meanwhile, the three major cloud providers (AWS, Azure, GCP) saw revenue growth accelerate from 35% in March to 43% in June, with operating margins up about 2 percentage points, showing industry fundamentals remain healthy.
— Dan Niles4x leverage was the main cause of the fund's blowup
The Situational Awareness fund's blowup was not due to wrong directional bets, but to using 4x leverage. If the underlying falls 25%, 4x leverage means a 100% loss, triggering liquidation. This is similar to the lesson of Long-Term Capital Management (LTCM) in 1998. After hearing about the fund's problems on July 29, Dan Niles judged that a short-term bottom was near, because fundamentals (token usage growth) had not deteriorated. He warns that leverage amplifies risk in both directions, especially when long and short positions are simultaneously unfavorable, which can trigger catastrophic selling.
— Dan NilesCloud providers' cash flow turned negative for the first time
Although cloud providers' revenue is accelerating and margins are improving, the market worries about deteriorating free cash flow. For example, Google's cash flow turned negative for the first time since its IPO, due to massive AI capital expenditures. Dan Niles believes this is similar to the dot-com bubble era: the technology revolution is real, but stocks could plunge 78% (Nasdaq 2000-2002). He expects strong industry growth over the next year, but once a hyperscaler cuts capex due to debt problems, it could trigger a chain reaction.
— Dan NilesData center political risk is the biggest short-term threat
Dan Niles points out that the biggest short-term risk to AI growth is not demand, but political resistance. A Gallup poll shows 71% of people oppose building data centers in their backyard, higher than the 53% who oppose nuclear power plants. Both parties rarely agree on opposing data centers, especially in red states like Texas. Hyperscalers have failed to effectively promote the jobs and tax benefits of data centers, while anti-business forces have successfully painted them as negative. He expects political risk to weigh on the market before the November midterm elections.
— Dan NilesChinese semiconductors will break the cyclical myth
Dan Niles believes the view that semiconductors are no longer cyclical is dangerous, and China could be the key to breaking this myth. He draws an analogy to Japan in the 1980s and South Korea in the 1990s entering the DRAM market with government support, eventually displacing US dominance. Today, China's CXMT (ChangXin Memory Technologies) and YMTC (Yangtze Memory Technologies) are expanding rapidly. CXMT plans to increase monthly capacity from 300,000 wafers to 500,000, and YMTC aims to surpass Samsung and SK Hynix in NAND. For China, semiconductor self-sufficiency is more important than aircraft carriers.
— Dan NilesAgentic AI will extend the cycle by at least a year
Dan Niles believes agentic AI is a brand-new phase, marked by the launch of the OpenClaw project on January 30 this year. The agentic phase consumes 10-100 times more tokens than chat AI, which will drive continued demand growth. He expects the stock market to have at least another year of upside, but warns of competition from Chinese memory chips. He reminds investors to watch data like a hawk and avoid excessive optimism or pessimism.
— Dan NilesSoftware faces AI disruption; security and gaming relatively safe
Dan Niles believes AI's impact on the software industry is huge. OpenAI and Anthropic's combined annualized revenue soared from $29 billion at the start of the year to $105 billion seven months later, and this spending must squeeze other software budgets. He favors three relatively safe areas: cybersecurity, recording systems, and video games. Recent moves like Salesforce partnering with Anthropic and Workday being acquired by Silver Lake suggest software stocks may be near a bottom, but security sector valuations are already high.
— Dan NilesCredit markets are the AI bubble's early warning system
Dan Niles emphasizes that credit markets are key to judging the AI bubble. He monitors daily the credit default swap (CDS) prices of hyperscalers like Microsoft, Google, and Nvidia, and finds they are already above the North American investment-grade average and at historic highs. Credit investors are more cautious than stock investors because bond returns are fixed and principal safety must be ensured. AI's massive capex relies on debt financing, and 30-year Treasury yields have risen to their highest since 2007, increasing financing costs and potentially becoming the trigger for a bubble burst.
— Dan NilesIn their own words · checked verbatim
There is a number of tokens produced and how much you can charge for each of those tokens. And what you've seen since the end of May is what you can charge for these tokens has gone down by about 50%.
Dan Niles4:03
The problem was that they were using 4x leverage. So, if you do the math and say: if you have a drawdown of 25 percent, but a leverage of 4 times, then you lose 100%, and at that point your fund is liquidated.
Dan Niles7:03
71% were against data centers and only 53% were against nuclear power. That's bad, right? I couldn't believe it when I saw it.
Dan Niles14:19
I think many investors greatly underestimate what China is doing. And I hear these arguments and I tell myself that this is exactly what people were thinking back in the 1980s when Japan entered the semiconductor industry.
Dan Niles21:28
The agent phase uses 10-100 times more tokens than the chat-based AI phase. So, I think you still have a long way to go, at least another year for the stock to go up.
Dan Niles27:18
When you have some of the largest companies in the world that generate the largest cash flow that have credit default swaps trading at premiums to North American investment-grade credit default swaps, that tells you about the ability of the capital markets to absorb that.
Dan Niles41:19
Figures
| Token unit price decline | 50% | 4:03 |
| Token output increase | 2.5x | 4:03 |
| Three major cloud providers' revenue growth (March) | 35% | 5:03 |
| Three major cloud providers' revenue growth (June) | 43% | 5:03 |
| Nvidia P/E ratio | 15x | 3:03 |
| Nasdaq 2000-2002 decline | 78% | 10:03 |
| Opposition to data centers | 71% | 14:19 |
| Opposition to nuclear power plants | 53% | 14:19 |
| OpenAI and Anthropic annualized revenue (start of year) | $29 billion | 31:18 |
| OpenAI and Anthropic annualized revenue (7 months later) | $105 billion | 31:18 |
Glossary
- Credit Default Swap (CDS)
- A financial derivative used to hedge bond default risk; its price reflects the market's expectation of default probability.
- Hyperscaler
- A giant that owns large-scale data centers and provides cloud services, such as AWS, Azure, and Google Cloud.
- Token
- The basic unit of text processed by AI models; token usage is a key indicator of AI demand.
- Agentic AI
- AI systems that can autonomously perform multi-step tasks, consuming more tokens than chat AI.
How to listen
Fund managers watching the AI investment cycle, tech stock investors, and founders who want to understand AI bubble risks and opportunities.
The opening pleasantries and the closing section about gaming can be skipped; the core content starts at 4 minutes.