If I have a Windows service with a config file that points to web services it needs to call, is it more secure to put a fake DNS name for the server being connected to, then update the HOSTS file to redirect outbound calls to the right IP address?
No, basically. Why would it be? If someone can read the DNS name from the config, then they can simply do a Ping or check the hosts file anyway.
Regardless, though, obscuring names and IP addresses is definitely not a way to do security and will simply make maintenance and management difficult for you.