Problem solved! There was a small sachet of grease included with the calliper kit, which I also used to lubricate both seals. I also used it to grease the plunger on the master cylinder and it now travels freely.
A line of text included with the master cylinder reading "Before installation lubricate the rubber bush on the washer" would have saved me about four hours trying to figure it out. The kits do not come with any instructions at all. I guess a brake guy would already know that, so I've learned something new today.
The outer washer with the rubber bush is there to prevent the inner washer bending under pressure. This was evident when I lubricated the plunger and rubber bush. After experimenting without the outer washer installed, the inner washer was bent from the centre out. I flattened it out with a persuader and put it all back together again. They're cheap crappy washers so it only took two hits to get it back to normal.
For those who are interested, to pass for registration; the law in Australia states that the brake lever needs to have at least 20% of its movement left when the brake is applied. Therefore, when you pull the lever through 80% of its travel the brake must be working at that point.
After reassembling everything I tapped the entire brake system all over with the handle of a screwdriver. If there is any air left in the system it should all float upwards. Sometimes air bubbles can form on the inside of the line and the fluid will pass beneath those bubbles. Tapping the line will dislodge such pockets of air. I left the cap off the reservoir so that the air (if any) can float up there overnight. Tomorrow I'll top up the fluid and bleed the system once more. The brake feels pretty good at the moment. It may get even better.
Just a word of advice if you have not played with disc brakes before. DO NOT ALLOW ANY BRAKE FLUID RESIDUE TO COME IN CONTACT WITH THE PADS OR THE DISC!
A friend of mine once helped me out doing the front disc brakes on a car I had. We bled the brakes and took it for a test drive. At the bottom of the driveway I gently hit the brake and then I heard a very loud bang.
Unbeknown to me, my friend did not wash his hands before he assembled his side. He merely wiped his hands with a rag, but there was residue still on his fingers. What was the bang? The passenger side locked up and the weight of the car ripped the calliper clean off. The pads were impregnated with fluid and in that state they could not be cleaned.
I got free beer for the night off my mate for that. Cool! LOL
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