Because this is your niece, you've got a vested interest on several levels. Of course you want to see your daughter acquire a backbone so she can learn to speak up for herself in all of her relationships now and for the rest of her life. Secondly, because you love your niece you want her to learn that domination and threats aren't likely to help her develop good friendship skills or feelings of empathy and respect for others.

Since your niece is either your sister's or your brother's child and the family obviously is "very close" what has kept you from talking to her parents? Could it be that you feel somewhat intimidated by her Mom/Dad so you've stayed silent? If your niece has learned her domineering ways from her parent(s) then it may also be true that your daughter is learning her passivity from you.

My suggestion is that you have a heart-to-heart talk with your sibling and discuss what you've observed in their girls' friendship, the effect it has on your daughter, and why you want to work together so that both little girls learn some valuable lessons about what it means to be a real friend to others and to themselves!