Zebrafish embryonic red blood cells (RBCs) develop in trunk intermediate mesoderm (IM), and early macrophages develop in the head, suggesting that local microenvironmental cues regulate differentiation of these two blood lineages. spadetail (spt) mutant embryos, which lack trunk paraxial mesoderm (PM) due to a cell-autonomous defect in tbx16, fail to produce embryonic RBCs but retain head macrophage development. In spt mutants, initial hematopoietic gene expression is absent in trunk IM, although endothelial and pronephric expression is retained, suggesting that early blood progenitor development is specifically disrupted. Using cell transplantation, we reveal that spt is required cell autonomously for early hematopoietic gene expression in trunk IM. Further, we uncover an interaction between embryonic trunk PM and blood progenitors that is essential for RBC development. Importantly, our data identify a hematopoietic microenvironment that allows embryonic RBC production in the zebrafish.