Why does Terminal not honor preferences?
If you click on &quot;Escape sequence…&quot; in that screenshot, you get to see the following:

What this doesn't tell you, though, is that this is normally taken care of in the file /etc/zshrc_Apple_Terminal, which is called from /etc/zshrc. There are several things that can prevent /etc/zshrc_Apple_Terminal from being called or which can override what it tries to do:

You are starting Zsh with zsh -d or zsh -f.
You have a file ${ZDOTDIR:-$HOME}/.zshenv or ${ZDOTDIR:-$HOME}/.zprofile in which you have setopt NO_rcs or setopt NO_globalrcs
The parameter $TERM_PROGRAM does not have the value Apple_Terminal.
Zsh does not have read access to /etc/zshrc_Apple_Terminal.
When /etc/zshrc_Apple_Terminal gets sourced, the parameter $INSIDE_EMACS is non-zero.
You define a function precmd sometime after /etc/zshrc_Apple_Terminal gets sourced, which then overrides the one defined by add-zsh-hook.

What you can do to debug:

Start a subshell without non-global config files and see if the bug happens there, too:
cd $(mktemp -d); HOME=$PWD ZDOTDIR=$PWD zsh

If the problem does not occur in this subshell, then that means the problem is somewhere in your non-global dotfiles. You can get a list of these files by doing
ls ${ZDOTDIR:-$HOME}/.z(log(in|out)|profile|sh(env|rc))(-^/)


Restart Zsh with exec zsh -vx and study the output from the beginning to see if /etc/zshrc_Apple_Terminal gets sourced and whether anything later overrides the precmd hook it sets up.