The problem at its root is in ssh and the key setup. The X Windows Xauth problem is a Red Herring. After found some additional research I found a thread that appears to match your problem. The thread in question is for a product from Dovetail technologies but manifest the same problem in ssh key exchanges.
EZYXW11E XtlibError: invalidDisplay xtInitialize XtToolkitError Can't open
FOTS1346 Permission denied, please try again.
EZYXW11E XtlibError: invalidDisplay xtInitialize XtToolkitError Can't open display: 172.24.30.28:0.0 Connection closed by UNKNOWN
FOTS2707 zsshSmfWritePipe: write(): EDC5113I Bad file descriptor. (errno2=0x05710034).
If the key is in place, the likely issue is incorrect permissions on the .ssh directory and files on the target system. The following commands in the home directory of the
sftp user will correct the permissions:
chmod 700 ~/.ssh
chmod 600 ~/.ssh/authorized_keys
The permissions on my USS system look like this:
IBMUSER> ls -la
drwx------ 2 IBMUSER OMVS 8192 May 11 09:15 .ssh
IBMUSER> ls -la .ssh
-rw------- 1 IBMUSER OMVS 399 May 11 09:15 authorized_keys