Original Mustang Dynamic Vibrato Setup Instructions from 1967 Fender Service Manual

Available here.
"The Mustang Dynamic Vibrato provides extremely smooth vibrato action and wide pitch variation. The correct position of the vibrato bar is when the vibrato spring posts at either end under the bar are straight up and down. When lighter or heavier gauge strings are used, the tension may vary, causing the bar to move out of normal position. The adjustment to bring the bar back to correct position may be made by inserting an Allen wrench into the holes on the top of the bar and turning in the appropriate direction. Turning clockwise will move the bar toward the neck and counterclockwise will move the bar away from the neck. It may be necessary to make this adjustment more than once; retuning the strings after each adjustment.
 
If extremely light gauge strings are used, the tension may vary more than may be compensated by the bar tension adjustment screws. Correct tension may be restored by removing the strings and then the entire vibrato unit from the body. Remove, then, the two springs attached to the lower slot at the bottom of the vibrato posts and re-attach them to the slot immediately above. Replace the vibrato unit to the body, string and tune to standard pitch. It may be once again necessary to adjust the spring tension at the two posts with the Allen wrench. When not in use, vibrato handle may be removed by loosening the screw at the end of the bar."

Compare this with my setup tips available here. Fender's original instructions call for the trem bar to be parallel to the strings and for the posts to be perpendicular to the strings. This allows both upward and downward pitch bends. My setup instructions don't allow upward bends but better overall tuning stability. YRMV. Let me know what works!

Fender Mustang Dynamic Vibrato Setup

Here are a couple tips on setting up the Fender Mustang Dynamic Vibrato. My '65 reissue came with no instructions and I had to use the Great Gazoogle for guidance on setting up the vibrato. This vibrato unit is unique to the Mustang. Note that the Stratocaster, Jazzmaster and Jaguar vibratos are referred to as "tremolos" or "trems." I'll do the same here. The Mustang vibrato consists of a base plate, two threaded posts which go through two holes in the plate and screw into a stop bar which anchors the strings and the vibrato bar. Underneath the base plate are two springs that connect the posts with the plate and provide tension against the strings. There are two adjustments that the user can make to the vibrato.

The first is the height of the stop bar, which is raised and lowered via two Allen screws accessible through the top of the bar. Counterclockwise turns will raise the stop bar, clockwise turns will lower the stop bar. When I bought my Mustang the stop bar was raised pretty high, which resulted in an uncomfortable hand position (I was used to a Stratocaster tremolo which I have set up flush with the top of the body of the guitar). The stop bar can be adjusted up and down to adjust the position of the vibrato arm to make it more or less parallel with the top of the guitar body. Adjusting the bar up will decrease tension, adjusting the bar down will increase tension. You will have to re-tune the guitar after the adjustments are made.

The second is to increase or decrease the spring tension. This is accomplished by moving the springs from one groove to another on the posts. This can only be done by removing the tremolo. I usually make this adjustment when I am putting new strings on the guitar. After you have removed the five screws that hold the base plate, examine the posts. The posts from a '65 reissue have three grooves and thus three choices for adjustment. The groove furthest from the baseplate will produce the highest tension to counter string tension, the groove closest to the baseplate will produce the lowest tension to counter string tension. Usually this adjustment will be necessary if you change string gauges. If you use .11s or up, use the furthest grove, .10s or lower use the middle or closest groove. The springs can be tricky to remove. I needed to use needle-nosed pliers to get them off and to secure them again to the post.

Since I rarely use the vibrato, my preference is to have the highest tension on the vibrato as possible. I have adjusted the springs to give the most tension even though I string my guitar with .10s. This is akin to using all five tremolo springs in a Stratocaster and screwing in the trem claw as far as possible. This has the effect of increasing the sustain. Since I rarely use the vibrato, this is definitely a plus with the Mustang as the light body produces less sustain than a Strat or a Tele. I also screw the stop bar down until there is barely enough room for the strings to pass under it. The disadvantage of this approach is that you really cannot use the vibrato bar. Since the stop bar is screwed down the vibrato bar will be really high and the tension will be very high as well. When the stop bar is higher and the tension lower, you can use your palm to rock the bar for a gentle vibrato, a nice effect.

A couple final tips. On the posts just below the threads there is another groove similar to the ones for the tension springs. This groove serves as the knife edge for the base plate. Make sure that the edge of the base plate is resting in this groove and not on the post threads. I usually have to pull up on the stop bar before I start bringing the strings up to tension in order to make sure that the base plate is in this groove. Finally, when you reassemble the vibrato, use a tiny bit of grease on the post threads to ensure easy adjustment.