It took me a while but I found it:
"No weird story can truly produce terror unless it is devised with all the care and verisimilitude of an actual hoax."
H.P. Lovecraft to Clark Ashton Smith (17 October 1930)
From:
http://www.turoks.net/Cabana/BovinomiconHistory.php--------
This looks like a more complete quote:
"H.P. Lovecraft in a letter to Clark Ashton Smith"
"My own rule is that no weird story can truly produce terror unless it is devised with all the care and verisimilitude of an actual hoax. The author must forget all about "short story technique" and build up a stark simple account, full of homely corroborative details, just as if he were actually trying to "put across" a deception in real life...as carefully as a crooked witness prepares a line of testimony with cross-examining lawyers in his mind. I take the place of the lawyers now and then-finding false spots in the original testimony, and thereupon rearranging details and motivations with a greater care for probability."
From:
http://thewhirligig.blogspot.com/2007/04/h.html--------------
In this:
http://www.chaosmatrix.org/library/chaos/texts/lovecraft_fn.html#fn18It says: Quoted in S.T. Joshi, "Afterword," in H.P.Lovecraft, The History of the Necronomicon (West Warmick, R.I.: Necronomicon Press, 1980), p.9.
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