The valve in the blue line should be turned in line with the line to the water heater to allow water to enter it.The valve in the red line - bypass - should be turned across to stop water from flowing thru. With the valves as i describe the water can flow into the heater thru the blue line then exit thru the red line. The valve handle turned inline with the pipe will allow flow and across the pipe will stop flow.
The other thing i see in the last picture you need to address the "kink" in the suction line from the tank. In that condition it will not work very good - think taking a garden hose and bending it shut sharply. It will either shut the flow down or stop it.
2005 Cruiser 29CK
2008 GMC 2500hd 4x4
Crew cab Long bed 6.0 gas
4.10 gear ratio