A random walk approach to predicting US 30-year home mortgage rates

Following the implications of term structure theory in an efficient bond market, this study formulates a random walk model that produces unbiased and efficient forecasts of the 30-year mortgage rate for 1987-2006. Forecast accuracy improves with a reduction in lead time but deteriorates with an increase in the forecast horizon. We find, however, no clear trend indicating that forecast accuracy has improved over time. From a more practical perspective, the random walk forecasts of the 30-year mortgage rate and prepayment premium (the spread between 30-year mortgage and 10-year Treasury rates) accurately predict directional change and thus are of value to a user. In exploring the view that the 30-year mortgage rate often moves in tandem with the 10-year Treasury rate, we further find that these rates are cointegrated and thus converge to an equilibrium relation in the long-run.