Thanks for the responses so far. Unfortunately I am home for the long weekend in Canada right now and the bike is back in WA state so I can't show a photo but, I found a picture of my derailleur on ebay. It's an old 7 speed XT from the late 80s/early 90s I believe.

I have the axle about centered in the dropout mostly because that is as far as the adjustment screws would go. I wanted it as far forward as possible thinking quicker handling but sounds like that's not the way to go according to CravenM. The large cog on the cassette is a 32 and I believe it is a 26-36-46 in front.

Perhaps this might indicate something: when the chain is in the large rear and large front, there is barely enough chain to make the shift and the derailleur is reaching way forward. However, when in the small rear and small front, there is too much chain and the derailleur is bottomed out meaning it can't take up anymore slack. This really has me scratching my head. I have built a few bikes and never had this problem. Hope I am clear and again, sorry for no photos of the bike.