I spent another hour on poking around with this and found the following.
I have build settings for WinAVR-20100110. If sh was in the path Id get the build errors described above. (I solved that by renaming sh.exe to sh_nope.exe)
What I found is I think WinAVR-20100110's version of make doesn't pay attention to the env variable SHELL=CMD.exe So setting SHELL=CMD.exe under Build Settings -> Compiler -> 'Path environment variable' doesn't work as expected. The ultimate reason my makefile fails is tools are being called using sh.exe instead of the default CMD.exe.