mkisofs -R -U -D -hide-rr-moved -cache-inodes -no-bak -pad KNOPPIX_folder | nice -5 create_compressed_fs - 65536 > KNOPPIX
Why don't you use the option "-f"
Code:
create_compressed_fs --help
as in the HowTo?

You need a huge amount of space, either within RAM or within disk (swap file, swap partition or output file).