As we pointed out last week, the direction of the bond markets is being determined by the rise and fall of the Federal funds rate -- the rate banks charge for the use of their excess reserves. The market is a dealers market following the funds rate and because there is little participation by legitimate retail buyers, the markets lack any real depth. Dealers had pinned their expectations on the idea that the Fed funds rate would decline to the 13 percent area last week, but they were fooled again.

Commercial banks like to dress up their quarterly financial statements by showing large sums of cash in their assets. Because of this, the banks bid up the cost of overnight money (Federal funds) to the 15 percent level by Friday a week ago. By all rights, so the dealers thought, the funds rate would decline by the end of March.

But a technical consideration came into play. Government bond dealers had just come through a couple of weeks of heavy Treasury financings and were carryiung large positions of unsold inventory. At the same time several corporate issues were priced cheaply against comparable Treasuries and purchased the corporates. As one dealer said, "We just rearranged the deck chairs on the Titanic, we traded one bond for another and still had the same positions."

Excessive inventory was also a problem in the municipal markets.

Dealers kept trading high-grade bonds back and forth to one another at higher prices, "and when the music stopped, prices dropped like a rock and the dealers were caught with a lot of bonds with big paper losses," admitted a dealer who should know.

The bottom line is that these large positions must be financed each night. The dealers try to do this by borrowing funds directly from their customers and putting up their bonds as collateral (a repurchase agreement) or by borrowing directly from big commercial banks and putting up their bonds as collateral. The interest rate that the banks charge the dealers is called the dealers loan rate. This rate is usually the Federal funds rate plus a quarter of one percent.

When the bond dealers went to the banks to borrow last week, their inventory was so large, that the banks had to borrow federal funds in order to accommodate the loan demand. This in turn pushed the funds rate up to over 16 percent so that the dealers' loan rate was at least 16.5 percent. Since the coupons on their inventory was below this rate, the dealers were losing money and decided to sell their bonds by cutting prices. And so prices declined and yields rose throughout the week. A higher than expected producers price index released Friday also played Havoc with the market.

Because the market is still in poor technical condition and due to many other uncertainties, investors should stay within maturities out to five years. In the tax exempt-area, a large supply of three-year notes will be sold during April. Returns will fall between 7 3/4 and 9 percent. Several large brokerage houses will offer a three-year municipal unit investment trust on April 8 that should have a current return around 8 percent. They will come in $1,000 units, and this will be the first of many such trusts.

Finally, $1.7 billion of government-backed (H.U.D.) tax-exempt notes will be sold Tuesday. Six-month notes and nine-month notes will probably yield between 6.8 and 7 percent.

Also expected on Tuesday is a $3.2 billion New York state tax revenue anticipation note issue with maturities of six, nine and 12 months, that probably will return between 7.5 and 8 percent. Underwriters are expecting a MIG-1 rating.