steps to reproduce:
;; test line
(if (and (boundp 'overlay) (overlayp overlay)) (delete-overlay overlay))
(setq overlay (make-overlay 1 2))
(overlay-put overlay 'display "\nhello")
;; same result if you do this intead
;; (overlay-put overlay 'display (propertize "\nhello" 'cursor 0))

cursor does not display in the first line.