Fraser, who had career-threatening neck surgery in January, shot a 7-under-par 65 Friday. The Australian had a bogey-free round on the Hyatt Regency resort course, saving par with a 20-foot putt on 17. He had a two-round total of 11-under 133.
Watson was in the lead for much of the day, but a three-putt bogey on 18 left him with a 68.
K.T. Kim (67) was in third, three behind. Y.E. Yang (68) and three Australians -- John Senden, whose 64 included a hole-in-one on the second hole, Adam Scott (67) and Robert Allenby (68) were tied for fourth, four behind Fraser.
"You have to be patient on this course, and if you start to short-side yourself, you have to work pretty hard to make par," Fraser said. "That's what happened on 17.
"We all know the quality of the field, and it's probably the best week of the year we have. So we'll give it a shot and see how it goes."
British Open champion Darren Clarke and American Rickie Fowler, making his Australian pro debut after winning the world amateur championship in Adelaide in 2008, had 73s, leaving them in a group nine strokes behind Fraser. Defending champion Peter Senior shot 73 and was at 1-under, just one shot inside the cut of even-par 144.
Fraser said he had a disc prolapse in his neck, an injury exacerbated when he picked up his two-year-old son, Archie, at the Australian Open last year. A Melbourne specialist did the surgery.
"At one point I had lost pretty much all of the use of my right arm towards the end of last year and start of this year," he said. "It was quite painful. I was on a lot of medication to try and get the pain down.
"They got rid of the old disc, put in a new synthetic disc, put a carbon fibre cage in around that, and a metal plate, so it was pretty full on. If I hadn't had the operation there was no way I would have played again, so it was a pretty easy decision to make."
Yang, the 2009 U.S. PGA winner, said his experience on the slick Royal Melbourne greens at the Presidents Cup helped him prepare for this tournament.
"It's a little bit easier," Yang said. "It was good prep from last week to get ready for this week. There are some shorter holes I need to play well on my wedge and my nine iron."
He's sees some room for improvement on the weekend.
"I had a double bogey on each round, so considering the fact that I didn't really have a clean sheet, I think it's satisfactory," Yang said. "I think I can build on this, but I'm going to take whatever the golf course gives me right now."