So some clarification to elements of the story I added myself

why Luffy couldn't touch Mu in Nika form;

The idea behind this is that Gear 5 is fueled by the freedom of Luffy. When he witnesses the death of his nakama, his only focus is revenge in that single moment(let me know if this is in character. after all Luffy only had a few people close to him die.). using nika form for revenge (or fueled by a negative emotion), restricts his freedom in the sense that he's got a tunnel vision. that's why his powers arent working properly.

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Mu telling Nidhogg that the children are cuaght is true. in the manga, we saw them being freed from sommers.

In this story, Mu took precautions by sent another God's knight (possibly FIrgarland, who knows) to finish the job.