Despite a three-day week, the bond markets were extremely volatile. The rally that began on Dec. 12 carried over into Christmas week. vLong Treasuries advanced 8 to 10 points ($80 to $100 per $1,000 bond) while long high-grade municipals advanced 6 to 8 points in price. The corporate market was harder to follow since there were so few issues to track. But long corporates were up several points too.

The volatility surfaced in an unlikely area: the short Treasury bill market. At Monday's bill auctions, the average discounted yield on the three-month bill was 168 basis points lower (higher prices) than the previous week's auction, while the six-month average was down 139 points. But on Wednesday morning, after a sloppy year bill auction the day before, long bills opened 100 basis points higher (lower prices). These are unheard-of yield and price changes in the most liquid and highest quality short-term investments available.

The volatility exists because of the uncertainties surrounding interest rates. Have rates peaked or not? Will the rally be sustained or will prices decline to lower levels? To place this entire situation in perspective, it would help to look at the rally itself.

Two weeks ago, the Treasury market was in a free-fall state with no support. At the same time high interest rates had caused sharp declines in the commodity markets and in the financial future market.

The situation had deteriorated to the point that on Dec. 11, heavy margin calls were issued to the owners of financial futures contracts to put up additional funds to cover their sizable mounting losses. In the futures market, an investor can control a $100,000 government bond contract with a cash outlay of $2,000. The leverage is great. Many speculators had been wiped out in prior days and so the specter of a total collapse in the financial futures market loomed large and real. This was especially true because this time the cash market, which was in a virtual free fall, was leading the financial futures market downward.

However, on the morning of Dec. 12, a tremendous amount of organized support turned the sagging prices in the financial futures market around. The unforeseen rise in prices in the futures market halted the price decline in the cash market. The immediate result was that a crisis was averted in the futures market and prices in the cash market began moving up, following the futures market.

Dealers who had sold issues they didn't own in the cash market (short-selling) scurried about to cover their positions. A collateral squeeze ensued and prices kept rising. Retail buyers jumped in as prices rocketed off their lows. Economists said rates had peaked and "peak fever" set in. Then when a couple of prominent banks dropped their prime rates to 20 1/2 percent, the rally continued.

This long explanation sheds light on the question of whether the size of the recent price is legitimate. I think not. For the rally to continue, short rates must move lower. For one, dealers cannot hold bonds in inventory and pay 19 1/2 percent to carry them while they earn only 12 to 13 1/2 percent from the coupons. They will hold them only if they think prices will advance.

Therefore, given the technical circumstances behind the rally and given the fact that the Fed has shown no inclination to legitimitize the rally by lowering short rates, one would assume that the rally has gone too far too fast.

Further, the continuance of the rally depends on news favorable to the bond market. Given the volatility in the market, should any adverse news occur, the market will quickly reverse itself.

For the rally to continue, look for bearish economic news, a curtailment of bank lending, declining monetary aggregates and the Federal Reserve allowing the Federal Funds rate to decline. If these events do not occur near term, prices will decline and rates will rise again.