* May nonfarm payrolls up 38,000 vs. est 164,000
* Unemployment rate at 4.7 pct
* S&P financial index falls sharply, led by banks
* Indexes down: Dow 0.48 pct, S&P 0.44 pct, Nasdaq 0.50 pct (Updates to open)
By Tanya Agrawal and Yashaswini Swamynathan
June 3 (Reuters) - U.S. stocks dropped on Friday, led by banks, after much weaker-than-expected jobs data for May pointed to labor market weakness and raised doubts if the economy was healthy enough to absorb an interest rate hike in the coming months.
The Labor Department said nonfarm payrolls increased by only 38,000 last month, the smallest gain since September 2010 and well below economists' forecast of 164,000.
The jobless rate fell three-tenths of a percentage point to 4.7 percent, the lowest since November 2007. The decrease was in part due to a people dropping out of the labor force.
"It's a fairly disastrous payroll report," said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York.
Traders are now pricing in only a 2 percent chance of the Federal Reserve increasing rates in June, sharply lower than the 20 percent probability just before the payrolls data.
"June's definitely off the table. The Fed will definitely want to see a cleaner read on payrolls before taking rates higher again," Goldberg said.
The S&P 500 financial index tumbled 1.8 percent and was on track for its biggest one-day fall in about two months.
The dollar index sank 1.4 percent, touching a one- month low of 94.19, against a basket of major currencies.
At 9:37 a.m. ET (1337 GMT) the Dow Jones industrial average was down 85.12 points, or 0.48 percent, at 17,753.44.
The S&P 500 was down 9.35 points, or 0.44 percent, at 2,095.91 and the Nasdaq Composite was down 24.62 points, or 0.5 percent, at 4,946.75.
Half of the 10 major S&P sectors were lower. Financial stocks were the biggest losers, led by banks, which benefit from higher interest rates.
Goldman Sachs, Wells Fargo, JPMorgan, Bank of America and Citigroup fell between 2-4 percent.
JPMorgan was the biggest drag on the S&P 500, while Goldman Sachs weighed the most on the Dow.
In recent weeks global markets have been puzzling over what the Fed will do in the near term as relatively upbeat U.S. data have been eclipsed by a still-sluggish global economy and worries over the risk of Britain exiting the European Union.
Ambarella was up 6.4 percent at $45.18 after the chipmaker's quarterly results beat estimates. GoPro, which uses Ambarella's chips in its cameras, was up nearly 4 percent at $11.14.
Broadcom rose 6.2 percent to $164.31 after the chipmaker reported better-than-expected second quarter profit and revenue.
Advancing issues outnumbered decliners on the NYSE by 1,325 to 1,309. On the Nasdaq, 1,462 issues fell and 791 advanced.
The S&P 500 index showed 17 new 52-week highs and one new low, while the Nasdaq recorded 16 new highs and seven new lows. (Reporting by Tanya Agrawal and Yashaswini Swamynathan in Bengaluru; Editing by Savio D'Souza)