* May nonfarm payrolls up 38,000 vs. est 164,000
* Traders slash chances of a rate hike in June
* S&P financials set for biggest 1-day fall in 2 months
* Indexes down: Dow 0.25 pct, S&P 0.40 pct, Nasdaq 0.65 pct (Updates to early afternoon)
By Tanya Agrawal and Yashaswini Swamynathan
June 3 (Reuters) - Financial stocks led Wall Street lower in early afternoon trading on Friday after shockingly weak nonfarm payrolls data for May raised doubts if the economy could withstand an interest rate hike in the near term.
The U.S. Labor Department said payrolls increased by only 38,000 last month, the smallest gain since September 2010 and well below economists' forecasts of 164,000. The jobless rate fell to 4.7 percent, the lowest since November 2007.
"This was not a huge miss or off-the-mark, this was a shocking miss," said Mark Grant, managing director and fixed-income strategist at Hilltop Securities, Fort Lauderdale. "This will change the Fed's viewpoint dramatically, in my opinion."
Traders slashed the odds of the Federal Reserve raising rates in June to 4 percent after the data from 20 percent previously, according to CME Group's FedWatch program. The probability of a July rate hike was reduced to 34 percent from 49 percent.
"I think this (payrolls data) puts into serious question if the Fed is going to do anything for the year," Grant said.
The S&P financial index tumbled nearly 2 percent and was on track for its biggest one-day loss in nearly two months, while the KBW bank index fell 3.3 percent.
Goldman Sachs, Wells Fargo, JPMorgan, Bank of America and Citigroup dropped between 2-4 percent.
The S&P financial index had dipped 0.3 percent this year through Thursday, already making it the worst performing among the 10 major sectors. However, the index had risen 2.5 percent in the past month on prospects of a rate hike as soon as June.
At 12:18 p.m. ET the Dow Jones industrial average was down 44.03 points, or 0.25 percent, at 17,794.53.
The S&P 500 was down 8.33 points, or 0.4 percent, at 2,096.93.
The Nasdaq Composite was down 32.55 points, or 0.65 percent, at 4,938.82 and was on track to end a streak of seven days of gains.
The dollar index sank 1.5 percent to a one-month low against a basket of major currencies, while the U.S. 10-year yields were on track to mark the biggest one-day fall in two months.
Six of the 10 major S&P sectors were lower. The interest-rate sensitive utilities led the gainers with a 1.76 percent rise.
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.
Investors will now turn to Fed Chair Janet Yellen's speech on Monday for clues on when rates will be hiked following the dismal jobs data.
Among the few bright spots, Broadcom rose 5.8 percent to $164.03 after the chipmaker reported better-than-expected second quarter profit and revenue.
Declining issues outnumbered advancing ones on the NYSE by 1,561 to 1,371. On the Nasdaq, 1,813 issues fell and 906 advanced.
The S&P 500 index showed 33 new 52-week highs and one new low, while the Nasdaq recorded 36 new highs and 22 new lows. (Reporting by Tanya Agrawal and Yashaswini Swamynathan in Bengaluru; Editing by Savio D'Souza)