* Catalonia eschews formal independence declaration
* County's stock index up 1.6 pct, leads European gains
* Spanish/German bond yield gap 7 bps tighter (Writes through)
LONDON, Oct 11 (Reuters) - Spanish stocks and government bonds were in demand on Wednesday after Catalonia's leader stopped short of making a formal declaration of independence from Spain, taking the edge off a political crisis in the euro zone's fourth biggest economy.
Carles Puigdemont instead made only a symbolic declaration late on Tuesday, claiming a mandate to launch secession but suspending formal steps to that end.
"There was a chance Puigdemont would have made a decisive declaration, so now yields are dropping because there is room for negotiation left," said DZ Bank strategist Christian Lenk.
"Now the haggling continues and the ball is in the hands of Madrid."
Spain's benchmark IBEX rose as much as 1.6 percent, outperforming the pan-European STOXX 600 index which was just 0.1 percent higher in early deals.
Shares in Spanish banks Sabadell and CaixaBank , which have moved their legal bases from Catalonia to other parts of Spain since the October 1 referendum, rose around 2.4 percent.
The rally in Spanish stocks pushed the main world stocks index, the MSCI's 47-country 'All-World' index, to a fresh record high of 493.25 points.
The country's 10-year government bond yield -- which moves inversely to the price -- dropped 5 basis points to 1.65 percent in early trade before steadying at 1.67 percent, according to Tradeweb data.
The gap between Spanish and German 10-year government bond yields narrowed 7 bps at one stage to 118 bps . It had widened to 136 bps last week.
Meanwhile, the euro climbed against a broadly stronger dollar, hitting a two-week high of $1.18345.
Spanish government bond yields had risen sharply over the last week and a half after Catalans voted overwhelmingly -- albeit on a low turnout of 43 percent -- on Oct. 1 for independence in a referendum banned by authorities in Madrid.
While the Spanish government does not recognize the referendum or Catalonia's right to break away, Foreign Minister Alfonso Dastis said early Wednesday that there was room for talks within the framework of Spain's existing constitution.
A protracted standoff over the issue is now widely expected, but local markets have reversed some recent losses as an instant fracture has been avoided.
Though Spain was the outperformer on the day, other Southern European government debt was also in demand: Italian and Portuguese 10-year yields dropped 2 bps each.
Higher-rated European government bond yields rose ahead of expected supply, with Germany's 10-year government bond yield 1.5 bps higher at 0.46 percent.
Germany will sell 3 billion euros of five-year bonds, the Netherlands will auction bonds maturing in 2024 and Portugal is set to reopen its five and 10-year bonds.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s
(Reporting by Abhinav Ramnarayan; Editing by Karin Strohecker, John Stonestreet and Peter Graff)