Upgrade AVP or separate preamp/DAC for 2 channel?

If you're serious about 2-channel definitely go with a stereo preamp to handle the front L/R speakers and use the Onkyo to process the center/surround channels. The preamp can be one of the most important influences on the kind of sound you get from your system, and most good stereo pres (and obviously the ARC) will trounce what you get out of all but the best AVPs.

I'd just be a little hesitant to lock into the DAC section of the DSPre. As good as it probably is, the DAC world is progressing so rapidly it might be better to get a separate pre and DAC so you have more flexibility to upgrade the DAC going forward. ARC is great, but at that price level you should try at least a few others (in your system if at all possible) to see what really works best sonically for you in the context of your system. Best of luck.

In theory, if the stereo pre has a HT bypass (or even if it didn't) shouldn't the room correction still work for HT? Personally I wouldn't use the room correction for stereo listening, and with the 1028s I question needing the sub for that as well. So maybe this could still work if you're willing to let those things go for 2-channel?

As far as higher-end pre/pros I was thinking something at the level of the Bryston SP3 or above (actually I'd probably take an Anthem over the Denon as well). Would I put the Denon at that level? I can't say because I've never heard it (but I do have a Bryston stereo pre), but it seems highly unlikely to me. I'd want my pre/pro to at least come from a manufacturer with a reputation for creating really good stereo preamps if 2-channel is my priority. As far as I know Denon doesn't make any stereo preamps at all, so it's hard for me to believe the preamp section in the AVP stacks up to something from the likes of ARC or even Bryston. Oh, and then that questionable preamp section is housed in one box containing a whole bunch of digital processing and other power supplies (possibly not all that great and maybe even shared), etc. that could muck up the sound further if not isolated properly. Then again, maybe I'm just an audio snob.

If your priority is 2-channel it makes sense to me to put more of the money into a really good, dedicated stereo pre and let the Onkyo continue to handle the relatively less important surround duties, which it probaly handles just fine I'm guessing. Personally I'd sacrifice the room correction and sub for stereo listening if it means I could get something like the ARC in my pure 2-channel signal path. Then again, if you're willing to drop the coin on an expensive pre/pro that could work too, but make sure the analogue preamp section is well sorted out and matched to your overall system so you can reap the true benefits and potential for 2-channel. Just my $0.02 and hope this helps more than hurts.