* Employment report dims prospect of Fed rate hike
* S&P financials set for biggest 1-day fall in 2 months
* Utilities surge, lead all sectors
* Indexes down: Dow 0.25 pct, S&P 0.38 pct, Nasdaq 0.67 pct (Updates to late afternoon)
By Lewis Krauskopf
NEW YORK, June 3 (Reuters) - Financial stocks led Wall Street lower on Friday after a surprisingly weak jobs report for May prompted concerns about the U.S. economy and whether it can sustain a near-term interest rate hike.
The U.S. economy created the fewest number of jobs in more than 5-1/2-years in May as manufacturing and construction employment fell sharply. Nonfarm payrolls increased by only 38,000 jobs last month against economists' forecast for an increase of 164,000.
Traders significantly lowered their bets that the Federal Reserve will raise rates at its next meetings in June and July, with predictions at 6 percent for an increase at the Fed's June 14-15 meeting, down from about 20 percent on Thursday, according to the CME Group website.
The lowered expectations were reflected in the weakness in the financial sector, which is seen as benefiting in a rising rate environment. The group was off 1.4 percent, on pace for its worst fall in about two months, with declines in shares of large banks like Bank of America and Citigroup.
Utilities, a high-dividend-paying group whose appeal declines when rates go up, rose 2.1 percent.
"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 in Fort Lauderdale. "I think this puts into serious question if the Fed is going to do anything for the year."
The Dow Jones industrial average was down 44.95 points, or 0.25 percent, at 17,793.61, the S&P 500 lost 8.04 points, or 0.38 percent, at 2,097.22 and the Nasdaq Composite dropped 33.50 points, or 0.67 percent, at 4,937.86.
Six of 10 S&P sectors were lower in afternoon trading. The Nasdaq was set to snap a seven-day winning streak.
Stocks had fallen more steeply during the morning but pared back those losses by the afternoon, encouraging some investors.
"The market has opportunities to sell off this week, especially today, and we haven't seen that cascade of selling come in on a weak opening," said Bucky Hellwig, senior vice president at BB&T Wealth Management in Birmingham, Alabama. "It's still a negative number, but the response in stocks was not as negative as one would anticipate."
Following signals by the Fed last month, global markets have been bracing for a near-term interest rate increase. The U.S. central bank raised rates in December for the first time in nearly a decade.
Investors will now turn to Fed Chair Janet Yellen's speech on Monday for clues about the bank's next move.
The S&P 500 is up about 2.5 percent in 2016 after a gloomy start to the year amid jitters about the global economy and a volatile oil market.
Among the few bright spots on Friday, Broadcom rose 5.2 percent to $162.93 after the chipmaker reported better-than-expected quarterly profit and revenue.
Declining issues outnumbered advancing ones on the NYSE by 1,529 to 1,473, for a 1.04-to-1 ratio on the downside; on the Nasdaq, 1,807 issues fell and 990 advanced for a 1.83-to-1 ratio favoring decliners.
The S&P 500 posted 33 new 52-week highs and 1 new low; the Nasdaq recorded 40 new highs and 25 new lows. (Additional reporting by Jennifer Ablan in New York, Tanya Agrawal and Yashaswini Swamynathan in Bengaluru; Editing by Savio D'Souza and Nick Zieminski)