UK Prime Minister Starmer's political career is facing an existential crisis. Following the controversial appointment of Peter Mandelson, who is implicated in the Epstein case, as ambassador to the United States, key members of Starmer's inner circle resigned within 24 hours. Cabinet ministers are privately demanding his resignation or threatening to quit themselves, plunging British politics into severe turmoil.

This political crisis has rapidly spilled over into financial markets. On Monday, the UK's FTSE 100 index experienced a slight decline. The pound fell against the euro by as much as 0.5%, hitting its lowest level since January 22, though it later recovered some of those losses. The yield on UK 10-year government bonds rose, approaching its highest point since last November. Hedge funds are aggressively betting on further weakness for the pound through the options market, with trading volume for euro-pound options reaching its highest level since 2019.

Starmer's Chief of Staff, Morgan McSweeney, resigned on Sunday, stating he took "full responsibility" for recommending Mandelson's appointment. On Monday morning, Communications Director Tim Allan also announced his resignation, saying it was to "allow a new Downing Street team to be formed." This marks the second Chief of Staff Starmer has lost within 19 months, depriving the architect of the 2024 election victory of his most crucial political shield at a critical moment.

According to Bloomberg, officials at 10 Downing Street are preparing for a scenario where cabinet ministers privately call for the Prime Minister to step down or threaten resignation. An aide to one cabinet minister suggested Starmer's chances of surviving the week are "fifty-fifty." Health Secretary Wes Streeting and former Deputy Prime Minister Angela Rayner are seen as potential successors.

The political crisis has triggered market panic. Investors are reacting negatively to the prospect of Starmer or Chancellor Rachel Reeves leaving their posts, fearing that successors may be less committed to fiscal discipline. Yields on UK government bonds rose by up to 4 basis points in early Monday trading, with long-term bond yields seeing similar increases due to their sensitivity to budget outlook concerns.

Benjamin Picton, Senior Market Strategist at Rabobank, commented: "The resignation of his most senior adviser may buy Starmer some time, but signs of widespread backbench discontent, coupled with abysmal polling, are creating the impression that his days are numbered."

Hedge funds are increasing their bearish bets against the pound via the options market. Thomas Bureau, Global Head of FX Options Trading at Société Générale, noted that hedge fund flows are "unidirectional towards euro-pound, with heavy buying of call options." On February 5th, trading volume for euro-pound options hit its highest level since 2019, with volume for call options (betting on pound weakness) exceeding put options by 50%.

One-month implied volatility is at its highest level since last December. Goldman Sachs forecasts the pound will fall by 6% against the euro over the next 12 months, while Nomura expects a 3% decline by the end of April.

Cabinet ministers are preparing to force a leadership challenge. People familiar with the matter told Bloomberg that Downing Street officials are bracing for private demands for the Prime Minister's resignation or threats of resignation from cabinet members. An aide to a cabinet minister described Starmer's chances of lasting the week as a "coin toss."

Labour MP Andy McDonald said in a BBC interview on Monday: "It's in his hands. If he doesn't acknowledge the mistake he's made, doesn't recognize the problem in front of him and articulate clearly to us how he's going to deal with it, then I'm afraid it's over – if not today, certainly in the coming weeks or months."

Communications Director Allan's resignation statement seemed to hint at further changes, stating he was stepping down "to allow a new Downing Street team to be formed."

Party insiders expect Starmer may try to consolidate his position by inviting left-wing figures like Rayner back into the cabinet or promoting figures such as Energy Secretary Ed Miliband. However, some doubt Rayner would accept a role, as she is now closer to succeeding Starmer. One Labour official suggested the only way Starmer could survive until May's local elections would be as a lame duck, with rivals using that time to prepare their challenges.

Besides Rayner, at least six others are seen as potential successors, including Miliband, Streeting, Home Secretary Shabana Mahmood, Foreign Secretary Yvette Cooper, and Defence Secretary John Healey.

The Mandelson scandal continues to unfold. The crisis stems from Mandelson's association with Jeffrey Epstein. Newly disclosed information suggests that Mandelson, during his time as a minister over 15 years ago, appears to have leaked sensitive government information to Epstein. Parliament recently gained the right to access review documents concerning this diplomatic appointment, but these materials have not yet been made public.

Mandelson has previously resigned from government twice under controversy and is known as the "Prince of Darkness" for his political maneuvering. Starmer's judgment in appointing such a figure is under fresh scrutiny.

Cabinet Office Minister Pat McFadden told Sky News on Sunday: "Changing prime ministers every 18 months or two years is not good for the country. It leads to chaos and uncertainty economically, politically, and in terms of global reputation."

Even if Starmer survives the Mandelson issue, he faces peril in the coming weeks. The most immediate test is a by-election in Gorton and Denton on February 26th, a seat that should be a Labour stronghold but where the Green Party and Reform UK are now competing for first place. In local elections just over two months away, polls suggest Labour is set to lose a significant number of seats.

Markets are betting on further pound weakness. Activity in the options market shows a clear trader preference for buying exposure to a stronger euro against the pound, indicating the market views tail risks as skewed towards further sterling depreciation. While significant interest is focused around the UK local elections on May 7th, activity in April contracts is more pronounced, potentially representing pre-election hedging or early positioning.

Jamie Sanders, Director of FX Options Trading at RBC Capital Markets in London, said, "Specifically, we are seeing demand for euro-pound upside." This demand has led to a "significant mark-up" in the currency pair's implied volatility.

Jane Foley, Head of FX Strategy at Rabobank, stated that assuming the US dollar avoids another major sell-off, euro-pound could potentially move higher by mid-year, while pound-dollar could move lower. Starmer was previously expected to face a leadership challenge after May's local elections, but it may now happen sooner.

Foley added: "If the next prime minister looks likely to come from the left of the Labour Party, markets will be very wary of UK political turbulence."

Starmer's office indicated the Prime Minister might address the nation on Monday to outline next steps for delivering the change promised in Labour's 2024 manifesto. He has expressed frustration in recent days that the Mandelson crisis is distracting from his agenda. Following the loss of his second Chief of Staff, Starmer swiftly promoted McSweeney's former deputies, Jill Cuthbertson and Vidhya Alakeson, to jointly assume the role.