Where would the bond market be without the 508 point decline in the Dow Jones industrial average Monday? This is a question that investors, as well as the Reagan administration and Congress, should seriously consider. The probable answer is that long-term interest rates would be around 10.50 percent and short-term rates would be piercing their two-year highs while the dollar continued to weaken in the foreign exchange market.

But the Oct. 19 collapse changed all that, and hopefully it will convince the administration and Congress to come up with a cure for an economic system that could be terminally ill.

At the rate we are progressing, the economic policies of President Reagan could go down in history as the most disastrous in U.S. history. Scores of financial experts have repeatedly pointed to the budget and trade deficits as the major causes of our financial troubles, but to no avail. Undoubtedly last week's disaster will make a deeper impression upon the politicians than the rhetoric of the past several years.

With the stock market recouping some of its losses by the end of the week, one can only fear that the politicians will conclude that the dangers have passed and that Monday's debacle was a fluke. But if they are unable to get their act together, the next big decline in the market may be more severe and could lead to a depression. The world's stock markets sent America a message. The question is, was anybody in Washington listening?

So now we wait to see if there is any meaningful progress in Washington on curing our financial ills. In the meantime, investors must consider their options. There has been a "flight to quality," with investors seeking the safety of Treasury bills. A shortage of T-bills helped push returns on the 90-day bills 150 basis points lower in just two days. On Friday, Oct. 16, it looked as if the return on the new two-year note, to be auctioned the following Wednesday, would be 9.25 percent. By late Monday afternoon, that note could be purchased on a "when issued" basis at 7.50 percent, a decline of 175 basis points.

These remarkable yield declines resulted in the yield curve, as measured from the three month T-bill to the 30-year T-bond, increasing from 270 basis points to more than 350 basis points, and presenting investors with an extraordinary reason for extending maturities. Believing that yields would continue to fall because of the Federal Reserve's pledge to supply credit to the financial system, buyers began moving out the maturity curve. And the thought that a loss of $1 trillion to investors in the stock market would lead to slower economic growth was another compelling reason to extend maturities.

Fixed-income investors should remain cautious, with one eye on the stock market, looking for the aftershock, and the other eye on Washington, looking for positive action on the federal deficit. Stay with quality issues, preferably Treasuries, and at this time issues with maturities no longer than five years. The Treasury will announce on Wednesday its quarterly refunding, which will give investors a choice of a 3-year note, a 10-year bond and possibly a 30-year bond.

For municipal bond buyers, the rapid decline in Treasury rates far outpaced the decline in muni yields. Consequently, on a relative ratio basis of muni yields to Treasury yields, tax frees are more attractive now than they have been at any time in the past year. The greatest adjustment occurred in the 1- to 10-year maturity sector, but the most attractive ratios are in the 30-year sector. In fact, yields on some 30-year electric revenue issues equal the returns on long Treasuries. Stay with quality AAA and AA rated issues, and with state names if possible.

James E. Lebherz has 28 years' experience in fixed-income investments.