I think it is hard to reconcile the word of god thing, considering certain things. Sure, they say Sephiroth has never shown his full power, and in some fights I can believe that. But, c'mon, really? He's freaking died four times now, all because of Cloud. Surely by now he'd have said to himself "Fuck it, no sadistic toying with him this time, this time I just kill him. I can mock him once I take control of the lifestream and become supreme god of all, but for now just kill kill kill!"
As for the fight with Sephiroth and Zack... I can't decide why Seph-ylis (VD joke!) would hold back. I mean, he was insane, considered all humans to be traitors to his perceived race, and had just butchered an entire town. True, he had known Zack for a while and even showed some signs of being fond of Angeal's "puppy" but lets face it Sephiroth is not one to let sympathy hold him back, even when he still had any. I'd have to say it would just be out-and-out sadism, wanting to hurt people a little more, scare and awe them a bit more, before he finishes them off.
But, I will say even when he is being a sadistic prick during fights, he does seem to show some mocking respect to strength. Look at AC/C during the fight with Cloud. Swords locked, he takes the time to smirk and ask, depending on translation, "Where did you get this strength?" or "Interesting. What made you stronger?" While it doesn't seem overly important, he is basically commenting that Cloud is tougher than he used to be and wondering how it happened. It's almost like a compliment.
With that precedent, I could say Sephiroth might still respect Zack's skills and power as a fellow warrior but still want to toy with him, cat to mouse style, before offing the poor lad.