I understand what you're saying about the Stars and Bars being associated with some hate groups, but the same thing is true for the Stars and Stripes. Many of the largest chapters of the KKK were in northern states (Ohio claiming the largest, if memory serves) and the S&S was flown prominently at their rallies.
My point earlier — and still —is that many of the negative connotations associated with the Stars and Bars comes from northerners who don't understand a) what it means and b) why people fly it. Many, like me, consider it the battle flag of a proud people who have had their motivations twisted and degraded by the people who (I repeat) waged an illegal war against them and defeated them.
Don't get me wrong, I'm as opposed to slavery as any human can be. As were my ancestors from the mountains of North Carolina. But I don't think anybody who knows anything about history can support such a narrow view of the entire society of the south — then and now — and condemn people for wanting to hold to part of their heritage. To most modern southerners (as well as those who fought under it) the Stars and Bars was not a symbol of approval of slavery. It was the battle flag — pure and simple.
For those who think it has come to mean that, I concede it has for some. But I don't think it has for most people who want to fly it, unless it's the northerners who have picked it up as their (misguided) personal statement of racism.
And as an aside on that, you should remember that it ran just as rampant in the north when the freed or escaped slaves arrived as it did in the south — possibly worse, since northerners were not at all familiar with blacks and let their fears dictate how the newcomers were treated. Even Abe Lincoln, so revered by modern African-Americans and liberals, fought signing the Emancipation Proclamation for as long as he possibly could and did so only when further delay would have been political suicide. And even as he signed it he advocated rigid segregation.
Finally, to the question of why it's associated with bluegrass festivals; maybe because bluegrass is basically southern music. It is a combination of old-timey Southern Appalachian and the jazz chord progressions Bill Monroe (born in North Carolina) heard along the Mississippi around Memphis. And, despite a strong and growing following in the north in the last couple of decades, most of the bands still come from and play mainly in the south and mine their southern heritage for whatever cache it brings.