There is a song whose lyrics go something like: If you’re happy and you know it, clap your hands.
Does ‘it’ here refer to the fact that you are happy? How could somebody be happy and not know it?
Does ‘it’ here refer to the fact that you are happy? Yes it does.
Your other supposition is also correct.
One could be sad, and also feel IT. LOL.
As it is a lyrics, we should not take it as it is. It might be the case that the poet meant to say – we all are happy but we deny that. And therefore he/she urges us to look inside to find/know the happiness.
See if you could connect to the meaning 
Wow, you are going " deep " now Gray. But a thoughtful post.