Dec. 26 (Bloomberg) -- “I’m forever blowing bubbles, pretty bubbles in the air. They fly so high, nearly reach the sky.”

So goes the refrain of a 1918 hit tune. It could have been the theme song of investors piling into the U.S. Treasury market for the past six weeks.

Investors are so eager to escape the jaws of the credit crunch that on Dec. 9 they drove the three-month Treasury bill rate to negative territory for the first time since 1929. The same day, the Treasury sold $30 billion of four-week bills at a rate of zero percent.

Meanwhile, on Dec. 24, the 10-year U.S. Treasury note was yielding 2.18 percent, compared with 4.08 percent six months ago.

The flight to U.S. Treasuries is an Armageddon trade. It reflects investors’ panicked attempts to seek safety amid plummeting stock markets, collapsing property values and more than $1 trillion in losses and write-offs by banks worldwide.

Is this retreat from other markets creating a bubble in government bonds?

To Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., the answer is yes. “Treasuries have some bubble characteristics, certainly the Treasury bill does,” Gross said earlier this month. “A Treasury bill at zero percent is overvalued. Who could argue with that in terms of the return relative to the risk? There is no return.”

Hard to Argue

With yields at or near record lows, it’s hard to argue that Treasuries aren’t in bubble-land. Surely, the time will come when yields on U.S. government securities rise and prices fall, compliments of massive Federal Reserve pump-priming, steep interest-rate cuts, huge Treasury borrowings, the eventual pick- up in inflation -- maybe even a big drop in the dollar.

The bursting of a bubble in the U.S. government bond market would be a perilous event.

First, it would cause large losses for millions of investors, especially U.S. retirees who regard Treasury securities as the ultimate safe investment.

Second, it might threaten Treasuries’ status as the global “risk-free asset” and would damage the international stature of the U.S. Foreigners, who own about half of all Treasuries, might stop funding the country’s growing trade and budget deficits without an increase in U.S. interest rates.

Finally, a busted Treasury-market bubble could undermine the dollar’s global reserve-currency status, which in turn would spell higher U.S. interest rates, undercutting economic growth.

Hiding Place

A bigger issue may be how long U.S. government securities stay in bubble-land before bursting. Japan’s experience suggests it might be years. In that case, Treasuries might not be a bad place to hide for investors who are more concerned about the return of their capital than the return on their capital.

Choosing to remain invested in a bubble market with the intent of bailing out before it implodes requires market timing. That’s difficult, if not impossible, for the smartest investors.

The U.S. Treasury bubble is a direct consequence of those that preceded it. One of the axioms of the past two decades is that defusing bubbles in one part of the financial markets begets bubbles in others. Like a balloon, squeeze tightly in one area and a bulge shows up in another.

The current environment is a byproduct of bubbles bursting in metals, oil, global equities, developing-country securities and real estate.

Asia’s Crisis

Go back to early 1997. Asia’s smaller economies were surging, letting them maintain their over-valued currencies. When the bubble busted in Thailand that June, speculators forced the country’s central bank to abandon the baht’s peg to the U.S. dollar, driving the currency down more than 50 percent.

By early 1998, Thailand’s difficulties had morphed into an Asian problem that by mid-July began to damage the stock prices of U.S. banks as their troubled loans mounted. Later that year, Russia defaulted and hedge fund Long-Term Capital Management had to be bailed out. The Standard & Poor’s 500 Index tumbled 15 percent in six weeks, the Nasdaq Composite Index fell 30 percent in less than three months.

The Fed responded by cutting interest rates three times in late 1998. It also moved to neutralize concerns about the year- 2000 computer bug -- which never materialized -- by flooding markets with liquidity. The result averted a recession, but the pump-priming fueled the technology bubble. The Nasdaq soared 86 percent in 1999, and the S&P rallied 20 percent.

Bubble Fodder

Asian central banks added to the liquidity by buying hundreds of billions of dollars to keep their currencies competitive on world markets. To battle deflation, Japan adopted a zero-interest rate policy.

After the technology bubble popped in 2000, the Fed and the European Central Bank cut rates. These easy money policies attracted investors to stocks, bonds and real estate, fueling the latest bubbles.

Between Oct. 9, 2002, when U.S. stocks bottomed after the dot-com bubble burst, and their highs five years later, the S&P 500 doubled. By late last month, it had surrendered all of that gain.

While investors contemplate their next moves, it would be wise to keep in mind another part of the refrain of “I’m Forever Blowing Bubbles”:

“Then like my dreams, they fade and die. Fortune’s always hiding, I’ve looked everywhere.”

U.S. government securities still are the world’s major risk- free investment vehicle. You have to wonder, though, for how much longer.

(Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Michael R. Sesit in Paris at at msesit@bloomberg.net

Last Updated: December 25, 2008 18:01 EST