Holding your hands by your knees is not conducive to creating a balanced pleasure horse. All you are doing is encouraging the horse to work behind the bridle. In addition, your equitation is going to fall apart.
When you are showing, you would never put your hands down low like that, so it's not a good idea to train that way.
Ideally, a pleasure horse should be taught that when the rider goes in with the lower leg and spur, he should lift his middle up, and drop his head. As a horse gets more broke, it will take less hand to do so. Just a rock of the wrist will get the needed result.
I like to ride the horse forward and work first on taking the horse's face away and get him focusing on me as the rider. Also, it softens him up and help to get him more broke through the poll, neck, and wither. While at each gait (walk, jog, and lope), go out on a large circle. With two hands on the reins, drive your horse up into the bridle using your seat. Close your legs, and gently take the horse's head first to the outside of the circle and hold it. Keep the horse on the same path. You should only get the head around enough so that you can see the outside corner of his eye. Release rein pressure and leg pressure and allow the horse to work with a straight body. Close your legs, and gently take the horse's head to the inside of the circle the same way as the first direction. Hold for a few strides and release.
As your horse gets familiar with the process, you can add more pressure. Ask the horse to hold longer. As the horse relaxes, he should begin to lower his head, but since you are driving with your seat, you should still have the cadence and rhythm of a good gait.
When your horse is getting the concept of giving to the bit, take your horse back on a circle. Close your legs and drive forward with your seat. Together, lift your hands back (to engage the bit) and up, towards your belly button. Remember to keep back in your shoulders and drive from your seat. Hold the pressure until you feel your horse give to the bit. Gently release the pressure -- don't just drop the horse yet, as he's still learning to carry himself and you don't want him to fall onto his forehand.
As the horse becomes stronger and more familiar with what you are asking, hold the contact longer while driving the horse forward. At the lope, practice pushing his hip to the inside, with your outside leg. Your inside calf should lay against the horse to support the shoulder. Think about pushing your outside hip towards the horse's inside ear. Hold the pressure until your horse has given to the bit. Hold for a few strides longer, and release. If the horse falls forward, or pops up, go back in slowly and do the same thing.
Jog and lope boxes. Practice making a square corner, which will require your horse to sit back on his hock and push around the corner. You can also take your horse from a large circle down to a smaller circle in a spiral and back out.
Counter cantering is a great excercise -- not just in circles, but serpentine around the arena, make a figure eight, etc.
If you are not already working with a trainer, I suggest looking for one to at least haul in to lessons with.