* Catalonia eschews formal independence declaration
* Madrid stock index up 1.6 pct, leads European gains
* Spanish/German bond yield gap 7 bps tighter (Adds Rajoy statement, updates prices and graphic)
LONDON, Oct 11 (Reuters) - Spain's stocks and government bonds were in demand on Wednesday after Catalonia's leader stopped short of making a formal declaration of independence, 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."
Spanish Prime Minister Mariano Rajoy on Wednesday, however, took the first step towards activating article 155 of the Spanish constitution, a so-called nuclear option that would allow him to suspend Catalonia's political autonomy and take over the region.
Spain's benchmark IBEX rose as much as 1.6 percent at one point, outperforming the pan-European STOXX 600 index, which was up less than 0.1 percent.
Shares in Spanish banks Sabadell and CaixaBank , which have moved their legal bases from Catalonia to other parts of Spain since an Oct. 1 independence referendum, rose around 1.9 percent and 1.2 percent respectively.
The rally in Spanish stocks pushed the main global stocks index, MSCI's 47-country All-Country World Index , to a fresh record high of 493.25 points.
Spain'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.
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 recognise the referendum or Catalonia's right to break away, Foreign Minister Alfonso Dastis said early on Wednesday that there was room for talks within the framework of Spain's existing constitution.
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.
Portugal's 10-year bond yield hit its lowest level since December 2015 after strong auction results.
Higher-rated European government bond yields rose against a backdrop of strong supply, with Germany's 10-year government bond yield 1.5 bps higher at 0.46 percent.
Germany sold 2.395 billion euros of five-year bonds and the Netherlands was set to sell 5-7 billion euros of seven-year bonds.
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(Reporting by Abhinav Ramnarayan; Editing by Karin Strohecker/Jeremy Gaunt)