Although there was a host of new Treasury and municipal issues last week, activity was light and the bond market should have closed for the Labor Day holiday. It certainly was a good time to be on vacation in the face of a very apathetic and extremely dull market.

This uninteresting market atmosphere may be masking an underlying event: namely that the bond market rally, if not already over, is dying a slow death. This is not to say that interest rates will skyrocket, but further declines in rates may prove very difficult. The economy has slowed from an unsustainable pace, but still remains strong. Credit demands, both short- and long-term, have been surprisingly robust.

The municipal bond market provides a snapshot of the overall market. Since the rally began near the end of June, more than $11 billion in new issues have been marketed as investors became more positive in their outlook and as interest rates declined. But the dynamics of the tax-free market changed in the process. One major buyer initiated a large purchasing program that has helped the market. In the absence of strong buyers such as commercial banks and fire and casualty insurance companies, the municipal market needed the purchasing power of this major buyer along with open-end mutual funds and unit investment trusts (UITs).

Peter Gordon, municipal manager of the Rowe Price funds, adds that, "With the market going up, a lot of buyers became traders who bought and sold bonds for a one-quarter- to a one-half-a-point profit. When the returns on the UITs reached 10 percent, the retail demand for the UITs slowed and, consequently, the UITs' support of the market slowed as well. When the traders realize that they can't continue to make easy profits, they will leave the market, too. As a result, there will be an imbalance in the supply of new tax-free issues and the demand for them from buyers. At that point, the marketplace will reflect the true status of the market more accurately, and interest rates will rise."

Perhaps we are close to the "true status of the market." The municipal 30-day forward calendar is $3.6 billion, while the secondary market float of inventory, as advertised in the Blue List, is $1.7 billion. Municipal Market Data Inc. of Boston notes that this $1.7 billion is the highest level reached in the Blue List since April 12, 1984.

The bottom line for the municipal market is that, as rates have declined and the new-issue and secondary-market volume has increased, demand has decreased. In this situation, prices will be cut on the inventory, and yields will rise not only in the secondary market but on the new issues as well.