Makes sense, tho I don't have a proxy to try it. But get this...
I just tried it with my settings off again...and when you get that prompt for logon...if you just hit enter, it will go straight in...with your NT user authenticated as normal. no user/pass needed.
enter or cancel? i've seen that behavior when downloading files sometimes ... if you hit cancel, it let's you do it. i don't recall what the problem except that it was a bug in the way IIS handled the file. do you have all the latest SPs on your webserver?