This did end up being a XF2 bug, after all, but just a note to bear in mind that we do have an XFMG bug reports forum so generally if you suspect an issue with XFMG itself, the bug should be posted there.
But, indeed, as I said the problematic code was in the XF image driver itself on this occasion. The width value was being passed in for the height, making the watermark a lot bigger than it needs to be. Should be sorted for the next release.
I would say, however, that the actual watermark image you're using is very small compared to the size of the images that could be uploaded. You'd likely see a better quality watermark if you used a larger image.
That's too bad, I like the ability to control the size and position of the watermark. IMO there's nothing 'overwhelming' about the current watermark settings in XFMG 1.1.13 as they are simplistic and straight foreword.