We are engulfed in a nervous and confused bond market. The nervousness stems from the fact that everyone is so confused that they are unable to get a handle on the market, and, consequently, they really do not know what action to take. The fundamentals are there, but the technical factors are masking the proper course of action.

Consider the fundamentals: the economy is stronger than anticipated, the money supply has been growing rapidly, there has been no real progress on the budget deficits and the July tax cut will give impetus to the economy. Faced with these facts, investors would agree that the Federal Reserve will probably allow interest rates to rise in order to dampen a rekindling of inflation. But when?

Recent activity on the technical side has helped to push the federal funds rate and other short-term rates higher, which has led many to believe that the Fed has actually tightened. Yet the Fed continues to supply reserves to the banking system to seemingly keep the federal funds rate under 9 percent. Dealers are unsure which way to go, although they own most of the recent auctions. It's hoped that some direction will come from the July 12 meeting of the Federal Open Market Committee, which sets the direction of Fed policy.

In light of the Washington Public Power Supply System debacle, George Gregorio of E. F. Hutton recently published information concerning the validity of the "take-or-pay" contracts between joint-action agencies and their participants in various states. In group one were the stronger credits by virtue of those states having had specific statutory provisions passed by their legislatures for take or pay contracts. States in this group were Florida, Maine, Massachusetts, Michigan, North and South Carolina, Vermont and Virginia.

In the second group were states that had tested and approved the take-or-pay provisions in their state supreme courts: Georgia, Louisiana, Missouri and Texas.

Finally, in light of the WPPSS situation, the weakest credits with no specific legal backing of the take-or-pay contracts were California, Minnesota, Oregon, Washington and perhaps Nebraska.

Peter Gordon, who manages the Rowe Price municipal bond funds, feels that at this time even the WPPSS bonds for project Nos. 1 and 3 are a poor risk despite the statement by the Bonneville Power Authority that the principal and interest would be paid on those bonds. Gordon reasons that if the system does go into bankruptcy, the legal uncertainly would be great and that there is no way to assess the final outcome. Even though the BPA might make payments to WPPSS, there is no protection that those payments will go to the bondholders. The bankruptcy judge would decide this. Consequently, Gordon feels that you are currently not being paid enough to assume the huge amount of risk overhanging these bonds.

In light of the current market uncertainty, Gordon counsels using one- to five-year municipals. He points out that a five-year tax exempt returns around 175 basis points more yield than a one-year maturity, a very wide spread, and so he especially favors the three- to five-year range.

On Wednesday, $2.2 billion of tax-exempt HUD-backed project notes will be offered. They will mature monthly from November 1983 through August 1984. They should return between 4.8 percent and 5.8 percent.