Tough call on that one. People with mental illness are more likely to be a victim of a crime than a perpetrator, but the fact that her delusions involve him directly would have me worried too, and he is at an age where he couldn't fight back.
You mention your sister - how does your niece feel about this? She is the one you should be talking too. For all you know maybe she feels safer if he isn't in the same room. She may not trust herself. Talking with her is important. She may not feel great about the situation. It is a bit of a blow to be told you can't be around someone you love because you may be unsafe, but she'll be much more understanding of the situation if you involve her in the conversation and affirm that you love her.
This is a discussion that need to be between you and your niece, not you and her mother. She is 30 and deserves to be treated with honesty and respect.
It isn't like you are throwing her out on the street, you are giving her a place to call home. If your sister can't appreciate that you do this for her daughter - then there isn't going to be much convincing her of anything.
I do hope that one day you can trust her stability enough that she can be a fully participating member of the family. Until then, you do what you must do to know your son is safe.
I was diagnosed as a paranoid schizophrenic and I have two children of my own, who I take very good care of. I also am very capable of babysitting my nephews and nieces. I have been on my medication non stop for three years and I show no signs of the illness. On the other hand if your niece is making claims about the devil and creatures, etc. I think her medication may need to be adjusted. It's not necessary to fear people with a serious mental illness. It is rare for someone with schizophrenia to become violent. Although, it is your son and only you understand her behavior because you are around her so if you feel the motherly instinct to protect, then you should protect your son.