That’s what I have enabled. That setting behaves differently between Touch Bar and non Touch Bar macs. On non Touch Bar Macs, you can hit space or enter to interact with a pop up dialog. On Touch Bar Macs, the tab key skips over certain UI elements as if they don’t exist. “Conveniently”, those elements are on the Touch Bar.

I'm not sure if this solves your problem, because I'm still on a non-TB Mac, but you can use CMD + [first letter] to select dialog options. For example, if you're closing an app and are asked if you want to save an open file, the dialog might have "Yes" preselected, but also let you choose "Don't save". If you hit CMD + D it will choose the "Don't save" option. Same thing for something that might say "All files" you can hit CMD + A to select it.

I just took some time to try this and it didn’t work. I think the Touch Bar acts as another device and UI prompts get forwarded to them. Thank you for the suggestion though.