"X is dreaded by Y", who is the one causing the dread - and who is on the receiving end?
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Well, you could say X is dreaded by Y (where Y is the frightened one). But it sounds a bit odd.
Y dreads X is shorter and easier to grasp.
Y is really scared of X is longer but actually more likely to used, I think.
X is causing the dread, and Y is affected by it. The verb means "to fear": X is feared by Y, i.e. Y fears X. If you are dreaded, you cause dread. If you have dread, you dread something dreadful.
I know, dreadful (causing dread) isn't entirely logical. The suffix -ful is to blame, because it is used in different ways; consider "hopeful" (person experiencing hope, or thing causing hope) and "painful" (thing causing pain).
The verb to dread was once also used in the opposite sense "to cause fear", but this sense is now obsolete; the Oxford English Dictionary's latest quotation of this sense is from 1681.
It seems that it could read either way. Using dreaded as a transitive verb it reads X fears Y. Using it as an adjective Y fears X. I do agree with the others that i's unclear and probably a new construction is probably best. I vote for just 'X dreads Y'.
If I were to say
He dreads the test tomorrow
It means that 'he' is feeling worry or fear regarding the test tomorrow. I could also apply the passive voice
The test tomorrow is dreaded by him
While I am not one who pushes for limitation of passive, as many do, I would probably avoid it in this case.
Therefore, in your example (X is dreaded Y), X is the scary thing, though I would probably opt instead for the construction
Y dreads X
If you are looking for a more comfortable usage of the word 'dreaded', it is most often applied as an adjective:
The dreaded demon walked towards her.
where 'dreaded' means 'very scary'.
The clause is in passive voice, so the noun before the verb is the direct object of the verb, and the one following the word "by" is the ablative object (which is essentially the same as being the subject of the verb).
The passive-voice "X is dreaded by Y" has the same meaning as the active-voice "Y dreads X".