Hedge funds are increasing their wagers on a further weakening of the British pound as the political outlook for UK Prime Minister Keir Starmer grows increasingly uncertain.

On February 5th, the pound fell to its lowest level in two weeks against both the euro and the US dollar. This decline was driven by investor concerns over the stability of the Prime Minister's leadership and the Bank of England's proximity to initiating interest rate cuts. The political crisis deepened over the weekend, delivering another blow to the currency, following the resignation of Starmer's chief of staff. The resignation was prompted by the appointment of Peter Mandelson as the ambassador to the United States.

Similar to price movements observed around the November budget announcement, options traders are showing a preference for using the euro as the primary vehicle to hedge against UK-specific risks. Last week, the premium for hedging against a decline in the pound versus the euro over the next month, compared to hedging against a rise, climbed to its highest level since late November. This also marked the largest weekly increase since July.

Flows into euro/pound positions from hedge funds "remain a one-way street, with strong buying interest above," said Thomas Bureau, Global Head of FX Options Trading at Societe Generale, referring to the demand for call options following the market moves on February 5th. "Sterling trading volatility is akin to that of emerging markets, a consequence of broad US dollar strength and high sensitivity to geopolitical news."

These latest developments represent another setback for the pound, which depreciated by over 5% against the euro last year. Strategists at Goldman Sachs Group anticipate a 6% decline in the pound against the euro over the next twelve months, while Nomura Holdings forecasts a 3% depreciation by the end of April.

According to RBC Capital Markets, the pound was already under pressure ahead of the Bank of England's decision, given the increasingly precarious position of Starmer as the UK leader.